Question

Tax Savings Synergies This question illustrates how the merge of two firms can produce gains coming from lower tax payments. This, if the firms' cash-flows are sufficiently uncorrelated. Information Assume a very simple economy which lasts one period more, and has two equally- likely states: "up" and "down". The following figure shows the before-taxes profits of Ying Co. and Yang Co.: Before Takeover After Takeover 50 -20 30 up p=1/2 1/2 1/2 Ying Yang Ying Yang t=0 t=0 t=0 down -20 50 30 If the corporate tax rate applied to positive profits is 34% (recall that in practice companies' losses do not pay taxes); compute the merge synergies by answering the following parts. Express your answers using 1 decimal place.

PLEASE ANSWER IN FULL:

Before Takeover

1. Compute Ying Co. after-tax profits (or losses if negative):
   • At the "up" state : $________million.
   • At the "down" state: $_________million.
   • What are the expected after-tax profits at "t=0"? (value-weight using states' probabilities) A: $_________million.
2. Compute Yang Co. after-tax profits (or losses if negative) :
   • At the "up" state : $________million.
   • At the "down" state: $_________million.
   • What are the expected after-tax profits at "t=0"? A: $__________million.
3. Note that the companies aggregate after-tax profits expected at "t=0" adds up to $13 million. (use this to double check your previous results)

After Takeover

1. Compute Ying-Yang Co. after-tax profits (or losses if negative):
   • At the "up" state : $_________million.
   • At the "down" state: $________million.
   • What are the expected after-tax profits at "t=0"? A: $  million.  (verify that your answer is larger than $13 million)

Answer 1

Tax is 34%. Net profit when co earns 50M would be 33M and when Co earns 30M would be 19.80M

Ying Co After tax profits

• At the "up" state : $ 33 million.
• At the "down" state: -$ 20 million.
• What are the expected after-tax profits at "t=0"? (value-weight using states' probabilities) A: $6.5 million (33+20/2).

Yang Co After tax profits

• At the "up" state : $ -20 million.
• At the "down" state: $ 33 million.
• What are the expected after-tax profits at "t=0"? (value-weight using states' probabilities) A: $6.5 million (33+20/2).

After Takeover

1. Ying-Yang Co. after-tax profits (or losses if negative):
   • At the "up" state : $19.80million.
   • At the "down" state: $19.80million.
   • What are the expected after-tax profits at "t=0"? A: $ 19.80 (19.80+19.80/2) million.

We observe the profits of the company has increased from combined profits of 13M to 19.80 M. This has happened due to the losses being absorbed by the profit making entity thereby reducing the net tax outflow and ultimately increasing the after tax profits. Profits has increased by 6.80 M which can be cross verified as 20M * 34% = 6.8M i.e Tax Savings on losses.