Hayley Medical, Inc. is evaluating the acquisition of Health-o-Matic, Inc., which had a loss carryforward of $3.75 million, resulting from earlier operations. Hayley Medical can purchase Health-o-Matic for $4.5 million and liquidate the assets for $3.25 million. Hayley Medical expects earnings before taxes in the three years following the acquisition to be as follows: (These earnings are assumed to fall within the annual limit legally allowed for application of a tax loss carryforward resulting from the proposed acquisition.) Hayley Medical has a 40 percent tax rate and a cost of capital of 15 percent. The approximate maximum cash price Hayley Medical would be willing to pay for Health-o-Matic is ________.

Question

Hayley Medical, Inc. is evaluating the acquisition of Health-o-Matic, Inc., which had a loss carryforward of $3.75 million, resulting from earlier operations. Hayley Medical can purchase Health-o-Matic for $4.5 million and liquidate the assets for $3.25 million. Hayley Medical expects earnings before taxes in the three years following the acquisition to be as follows:  (These earnings are assumed to fall within the annual limit legally allowed for application of a tax loss carryforward resulting from the proposed acquisition.) Hayley Medical has a 40 percent tax rate and a cost of capital of 15 percent. The approximate maximum cash price Hayley Medical would be willing to pay for Health-o-Matic is ________.

Quizplus · Accepted Answer

First, we need to calculate the present value of the tax shield from the loss carryforward:

PV(Tax Shield) = Loss Carryforward * Tax Rate = $3.75 million * 40% = $1.5 million

Next, we need to calculate the earnings before taxes (EBT) for each year, taking into account the tax shield:

Year 1 EBT = $400,000 - $1.5 million = -$1.1 million (LCT applied)
Year 2 EBT = $1.2 million - $1.5 million = -$300,000 (LCT applied)
Year 3 EBT = $3 million - $1.5 million = $1.5 million (LCT fully utilized)

Then, we use the formula for the value of a tax shield:

Value of Tax Shield = PV(Tax Shield) * (1 - 1 / (1 + r)^n) / r
where r = cost of capital = 15%, n = number of years for tax shield = 3

Value of Tax Shield = $1.5 million * (1 - 1 / (1 + 0.15)^3) / 0.15 = $3.354 million

Finally, we can calculate the maximum cash price that Hayley Medical would be willing to pay:

Maximum Price = Liquidation Value of Assets + Present Value of Earnings + Value of Tax Shield
= $3.25 million + ($400,000 / 1.15) + ($1.2 million / (1.15^2)) + ($1.5 million / (1.15^3)) + $3.354 million
= $4.4096 million

Therefore, the approximate maximum cash price Hayley Medical would be willing to pay for Health-o-Matic is $4.4096 million or choice C.