Question

Tax effects of acquisition Connors Shoe Company is contemplating the acquisition of Salinas Boots, a firm that has shown large operating tax losses over the past few years. As a result of the acquisition, Connors believes that the total pretax profits of the merger will not change from their present level for 15 years. The tax loss carryforward of Salinas is $800,000, and Connors projects that its annual earnings before taxes will be $320,000 per year for each of the next 15 years. These earnings are assumed fall within the annual limit legally allowed for application of the tax loss carryforward resulting from the proposed merger. The firm is in the 27% tax bracket a. If Connors does not make the acquisition, what will be the company's tax liability and earnings after taxes each year over the next 15 years? b. If the acquisition is made, what will be the company's tax liability and earnings after taxes each year over the next 15 years? c. If Salinas can be acquired for $212,000 in cash, should Connors make the acquisition, judging on the basis of tax considerations? (Ignore thee time value of money.)

Please answer all parts of the question. Thank you!

Answer 1

Part (a)

Tax liability each year = Pre tax income x tax rate = $ 320,000 x 27% = $  86,400

Earnings after taxes each year = Pre tax income - tax liability = 320,000 - 86,400 = $  233,600

Part (b)

Year	Earnings before taxes	Cumulative earnings	Tax liability	After tax earnings
	A	B	T	A - T
0		(800,000)
1	320,000	(480,000)	-	320,000
2	320,000	(160,000)	-	320,000
3	320,000	160,000	43,200*	276,800
from year 4 - 15	320,000	480,000	86,400**	233,600

* calculated as 27% x 160,000

** calculated as 27% x 320,000

Part (c)

Total tax benefit on account of accumulated losses = Tax rate x losses = 27% x 800,000 = $ 216,000 > acquisition cost of $ 212,000. Hence, the acquisition should be done / made.