Subsidized Loan Financing and its Impact on the Cost of Capital and Levered Firm Value - A Non-Technical Reply to 'Adjustment of the WACC With Subsidized Debt in the Presence of Corporate Taxes: The N-Period Case'

Abstract

Debt financing with subsidizes interest rate has a multidimensional impact on the firm. Value of the levered equity, value of the debt and overall firm value will be different of those values with debt financing at market rate. Subsidized interest rate on debt does not create any additional cash flow and all the changes in values and the cost of capital are the result of the redistribution of cash flows among debt, equity and government, and subsequent reduction in financial risk due to lower leverage. In this note we show that the levered firm value with the loan provided at a rate below market rate is lower (or equal, in a no tax world) compared to the same firm value with the loan at market rate. For the given nominal value of debt the cost of capital of the levered firm with the subsidized interest rate is higher than the cost of capital of the same firm with the market cost of debt, and intuitive adjustment of the WACC by direct substitution of the contractual interest rate into the classic WACC formulation produces inconsistent cost of capital estimate and flawed valuation. Debt financing with subsidized interest rate converts into the gain for the levered equity. This value gain originates from the value transfer from debt to equity and to ensure correct and consistent cost of capital and value estimates we need properly incorporate the effect of the subsidy in the interest rate on the cost of the levered equity. Required return to the levered equity with subsidized debt financing does not depend on the contractual interest rate. Extended APV valuation performed by adding value of the loan subsidy to the sum of the unlevered firm value and the value of the tax shield is based on inconsistent value relationship and leads to false results. To illustrate our non-technical discussion we use perpetuity model and simple numerical example.