Tax benefits and price Hahn Textiles has a tax loss carry forward of $800,000. Two firms are interested in acquiring Hahn for the tax loss advantage. Reilly Investment Group has expected earnings before taxes of $200,000 per year for each of the next 7 years and a cost of capital of 15%. Webster Industries has expected earnings before taxes for the next 7 years as shown in the following table.
Webster Industries Year Earnings before taxes
1 $ 80,000
2 120,000
3 200,000
4 300,000
5 400,000
6 400,000
7 500,000
Both Reilly’s and Webster’s expected earnings are assumed to fall within the annual limit legally allowed for application of the tax loss carryforward resulting from the proposed merger (see footnote 2 on page 727). Webster has a cost of capital of 15%. Both firms are subject to a 40% tax rate on ordinary income.
a. What is the tax advantage of the merger each year for Reilly?
b. What is the tax advantage of the merger each year for Webster?
c. What is the maximum cash price each interested firm would be willing to pay for Hahn Textiles? (Hint: Calculate the present value of the tax advantages.)
d. Use your answers in parts a through c to explain why a target company can have different values to different potential acquiring firms.