Assume XYZ Corp. is considering a $10M project that they will depreciate
for tax purposes over a five year period. They expect $3.5M of cash income
each year, pay taxes at a rate of 34%, have an all-equity cost of capital
of 20% and the risk free rate is 10%. Calculate the value of this project
assuming that the tax shields from depreciation are risk free and that the
firm is all equity financed.
The answer explanation says that the depreciation tax shields should be
discounted at the after-tax rate of 10% * (1-.34) = 6.6%.
But aren't we calculating how much tax is saved and should therefore use
the tax rate of 34%, not 1-34%?
I do not understand B&M's explanation on page 539. It does not seem
intuitive to me. I am looking more for intuitive reasoning here rather
than recited formulas. Can anyone explain this in a simple way that makes
sense?
Josh