Question

How are the tax savings on interest accounted for in the usual way we calculate NPV? Why is it done this way?

please provide answers and give reasons and logic

Answer 1

Tax saving on interest accounted, in calculation of NPV is used in the form of weighted average cost of capital. when we calculate cost of debt, tax saving on interest on debt is considered and it reduces the cost of debt and as a result overall weighted average cost of capital is reduced. In NPV analysis any financial cash flow like loan capital receipts and repayments, loan interest payments, overdraft interest payments, dividend payments, share issues and buybacks are not considered.

So by incorporating tax savings on interest accounted is used in WACC which is used to discount the cash flow in NPV analysis. This is why finance cash flows are ignored, as the impact of finance is included by using the WACC as the discount rate