Chapter 17
Chapter 17
Chapter 17
Solutions to Problems
P17-1. LG 1, 3: Tax Effects of Acquisition
Intermediate
(a)
Years Earnings Tax Liability After-Tax
Earnings
1–15 $280,000 $112,000 $168,000
(c) With respect to tax considerations only, the merger would not be recommended because the
savings ($320,000) are less than the cost ($350,000). The merger must also be justified on the
basis of future operating benefits or on grounds consistent with the goal of maximizing
shareholder wealth.
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(b)
Net Profits Before Taxes Taxes [0.40 × (1)]
Year (1) (2)
1 $150,000 − $150 000 = 0 $0
2 $400,000 − $400,000 = 0 0
3 $450,000 − $450,000 = 0 0
4 $600,000 − $600,000 = 0 0
5 $600,000 − $200,000 = $400,000 160,000
Total taxes with merger $160,000
(b)
Webster Industries
Net Profit Before Tax Taxes [0.40 × (1)] Tax Advantage
Year (1) (2) (3)
1 $80,000 − $80,000 $0 $32,000
2 $120,000 − $120,000 0 48,000
3 $200,000 − $200,000 0 80,000
4 $300,000 − $300,000 0 120,000
5 $400,000 − $100,000 120,000 40,000
6 $400,000 160,000 0
7 $500,000 200,000 0
Total Tax Advantage $320,000
Calculator
Year Cash Flow × PVA Factor (15%) PV Solution
1–5 $25,000 × 3.352 $83,800 $83,803.88
6–10 $50,000 × (5.019 − 3.352) 83,350 53,330.68
Total present value of cash inflows $167,150 $167,134.56
Less Cost of acquisition 125,000 125,000.00
NPV $42,150 $42,134.56
Since the NPV is positive, the acquisition is recommended. Of course, the effects of a rise in
the overall cost of capital would need to be analyzed.
(b) PV of equipment purchase (12%, 10yrs.):
PV = $40,000 × 5.650 = $226,000
Calculator solution: $226,008.92
NPV = $226,000 − $125,000 = $101,000
The purchase of equipment results in a higher NPV ($101,000 versus $42,150). This is
partially due to the lower discount factor (12% versus 15%). The equipment purchase is
recommended.
(c) PV of cash inflows
Calculator
Year Cash Flow × PVIFA12% PV Solution
1–5 $25,000 × 3.605 $90,125 $ 90,119.41
6–10 $50,000 × (5.650 − 3.605) 102,250 102,272.34
Total present value of cash inflows $192,375 $192,391.75
Less Cost of acquisition 125,000 125,000.00
NPV $67,375 $67,391.75
No, the recommendation would not change. The NPV of the equipment purchase ($101,000)
remains greater than the NPV of the acquisition ($67,375).
The ratio of exchange of shares is the ratio of the amount paid per share of the target firm to the
market price of the acquiring firm’s shares. The market price ratio of exchange indicates the
amount of market price of the acquiring firm given for every $1.00 of the acquired firm.
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3.6
3.2
3
Postmerger, .6 Exhange Ratio
2.8
EPS ($)
2.6
2.4
Premerger
2.2
2
2006 2007 2008 2009 2010 2011
Year
(d) Graham & Sons’ shareholders are much better off at the 0.8 ratio of exchange. The
management would probably recommend that the firm accept the merger. If the ratio is 0.6,
between 2010 and 2011, the EPS falls below what the firm would have earned without being
acquired. Here management would probably recommend the merger be rejected.