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

To determine the tax advantage of the acquisition, we need to calculate the present value of the tax shield resulting from the loss carryforward.

Step 1: Calculate the present value of the cash flows from operations for the next 3 years:
PV(CF) = ($1,000,000/1.10) + ($1,750,000/1.10^2) + ($2,500,000/1.10^3) = $4,472,527

Step 2: Calculate the present value of the tax shield resulting from the loss carryforward:
PV(TS) = $2.75 million x 0.40 x (1 - 1 / 1.10^3) / 0.10 = $842,000

Step 3: Calculate the total present value of the tax advantage:
PV(TA) = PV(TS) - (Purchase price - Liquidation value) = $842,000 - ($3,500,000 - $1,250,000) = $592,000

Therefore, the total present value of tax advantage of the acquisition in the following three years is $842,000, which corresponds to answer choice B.

Maxi, Inc Is Evaluating the Acquisition of Mini, Inc