How does subsidized financing affect the value of a project?

Banking & FinanceFinance ManagementGrowth & Empowerment

In the Adjusted Present Value (APV) approach, the after-tax subsidy is applied on after-tax cost of debt. That is, the company availing the financial subsidy gets a tax relief on their after-tax cost of loans. The debt of a company directly affects its value and hence the after-tax cost of debt also affects the company's finances. In fact, the companies get both savings in the tax paid as well as on the interest tax shield.

Subsidized Financing Increases the Value of a Project

A company paying 15 percent tax and receiving 5 percent subsidy will have to pay the interest at 10 per cent per annum on which it will also get the income tax shield. Therefore, the company gets a double benefit due to the subsidy offered on its interest to be paid back to the market. Subsidized financing thus increases the value of a project.

  • The subsidy on debt is applied on an after-tax basis. That is, once the company pays back the interest, it gets the subsidy on the remaining amount of debt.

  • Since interests on availed debt has been applied after tax, a portion of the subsidy is calculated on the debt acquired from the market.

  • Thus, the benefit of interest subsidy creates more value to the firm, although the project may not be economically profitable.

Why is Subsidized Financing Considered Valuable?

Subsidized financing affects the debt to be repaid by a company. When acompany raises funds for a project, it may acquire the loans knowing that it will get a portion of the interest it has to pay from the government.

  • The subsidy offered by the government on the after-tax cost of debt helps the company create more value in its investment project.

  • After-tax debt means that the tax has already been paid.

  • When a company gets an after-tax benefit, it is applicable to both its interest and the total amount of debt acquired from the market.

  • That means, more the debt acquired from the market, more will be the value of interest subsidy by the government.

Therefore, subsidized financing will create more value to a project by reducing the payable debt by the subsidizing financing-effect.

Subsidized Financing is Not Related to Profitability

Although subsidized financing creates more value in a project, for the financing effects, the projects may not be economically profitable.

  • Subsidized financing does not guarantee profits or success of a company.

  • Subsidized financing is in no way related to the profitability of the company, although more value added due to assistance in the core of the company's finances should help the company to grow and sustain the competition in the market.

raja
Updated on 10-Jan-2022 12:01:37

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