What is an interest subsidy? How do you calculate the value of an interest subsidy?

What will be an ideal response?

Answer: Interest subsidies arise when governments are willing to lend to corporations at below market interest rates. Such subsidies add value to a project. The appropriate discount rate for an interest subsidy is the market's required rate of return on the debt of the corporation because the corporation is just as likely to default on a subsidized loan from the government as it is on a normal loan at market interest rates. Suppose that the government lets a corporation borrow a principal of D for one period at a subsidized interest rate of rS < rD, which is the market's required rate of return on the corporation's debt. The corporation borrows D in the first period, and it repays (1 + rS)D in the second period. Because the actual interest payment is deductible, the corporation also gets a tax deduction of τ rS D in the second period. The present value of the cash flows of the subsidized debt discounted at the market's required rate of return on the corporation's debt is therefore
D - [(1 + rs) D / (1 + rD)] + [τ rsD / (1 + rD)] = [(rD - rs)D / (1 + rD)] + [τ rs D / (1 + rD)]
The value of a loan at a subsidized, below-market, interest rate has two components: the present value of the interest subsidy, which is the difference between the interest paid on a market loan and the interest on the subsidized loan, plus the present value of the actual interest tax shield. In both cases, the present value is taken at the market's required rate of return on the debt.