Maxi, Inc. is evaluating the acquisition of Mini, Inc., which had a loss carryforward of $2.75 million which resulted from earlier operations. Maxi can purchase Mini for $3.5 million and liquidate the assets for $1.25 million. Maxi expects earnings before taxes in the three years following the acquisition to be as follows: (These earnings are assumed to fall within the limit legally allowed for application of a tax loss carryforward resulting from the proposed acquisition.) Maxi has a 40 percent tax rate and a cost of capital of 10 percent. The total present value of tax advantage of the acquisition in the following three years is ________.

Question

Maxi, Inc. is evaluating the acquisition of Mini, Inc., which had a loss carryforward of $2.75 million which resulted from earlier operations. Maxi can purchase Mini for $3.5 million and liquidate the assets for $1.25 million. Maxi expects earnings before taxes in the three years following the acquisition to be as follows:  (These earnings are assumed to fall within the limit legally allowed for application of a tax loss carryforward resulting from the proposed acquisition.) Maxi has a 40 percent tax rate and a cost of capital of 10 percent. The total present value of tax advantage of the acquisition in the following three years is ________.

Quizplus · Accepted Answer

The tax advantage of the acquisition can be calculated as the present value of the tax savings resulting from the use of the loss carryforward.

Step 1: Calculate the taxable income (TI) for each of the three years following the acquisition, taking into account the loss carryforward:

Year 1: TI = $3,000,000 - $2,750,000 = $250,000 
Year 2: TI = $4,000,000 
Year 3: TI = $5,000,000

Step 2: Calculate the tax liability (TL) for each year:

Year 1: TL = 40% x $250,000 = $100,000 
Year 2: TL = 40% x $4,000,000 = $1,600,000 
Year 3: TL = 40% x $5,000,000 = $2,000,000

Step 3: Calculate the tax savings (TS) resulting from the use of the loss carryforward:

Year 1: TS = 40% x $2,750,000 = $1,100,000 
Year 2: TS = 40% x $250,000 = $100,000 
Year 3: TS = 0 (since the loss carryforward will have been fully utilized)

Step 4: Calculate the present value of the tax savings using the cost of capital:

PV(TS) = $1,100,000 / (1 + 0.10) + $100,000 / (1 + 0.10)^2 
PV(TS) = $1,004,545

Step 5: Subtract the purchase price and the liquidation value from the present value of the tax savings to get the net present value (NPV) of the acquisition:

NPV = PV(TS) - $3,500,000 + $1,250,000 
NPV = $1,004,545 - $2,250,000 
NPV = -$1,245,455

Since the NPV of the acquisition is negative, Maxi should not acquire Mini.

Maxi, Inc Is Evaluating the Acquisition of Mini, Inc