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

To calculate the maximum cash price Hayley Medical would be willing to pay for Health-o-Matic, we need to find out the present value of the tax savings that would result from acquiring Health-o-Matic with its loss carryforward.

1. First, let's calculate the tax savings for each year by applying Health-o-Matic's loss carryforward to Hayley Medical's earnings before taxes:

Year 1 tax savings = $3.75 million × 40% = $1.5 million
Year 2 tax savings = $3.75 million × 40% = $1.5 million
Year 3 tax savings = $2 million × 40% = $0.8 million

2. Next, let's calculate the present value of these tax savings using Hayley Medical's cost of capital of 15%:

PV of Year 1 tax savings = $1.5 million ÷ (1 + 0.15)^1 = $1.304 million
PV of Year 2 tax savings = $1.5 million ÷ (1 + 0.15)^2 = $1.132 million
PV of Year 3 tax savings = $0.8 million ÷ (1 + 0.15)^3 = $0.470 million

3. Finally, we can calculate the total present value of the tax savings as follows:

Total PV of tax savings = $1.304 million + $1.132 million + $0.470 million = $2.906 million

4. Since Hayley Medical can purchase Health-o-Matic for $4.5 million and liquidate the assets for $3.25 million, the net cost of the acquisition would be $1.25 million. Therefore, the maximum cash price Hayley Medical would be willing to pay for Health-o-Matic is:

Maximum price = net cost + total PV of tax savings = $1.25 million + $2.906 million = $4.156 million

Therefore, the best choice is (C) $4,410,000.