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Hudson expects to have earnings before taxes of

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Unformatted text preview: diversify its operations, Hudson Company, a molder of plastics, has acquired Bergen through a merger. Hudson expects to have earnings before taxes of $300,000 per year. We assume that these earnings are realized, that they fall within the annual limit that is legally allowed for application of the tax loss carryforward resulting from the merger (see footnote 4), that the Bergen portion of the merged firm just breaks even, and that Hudson is in the 40% tax bracket. The total taxes paid by the two firms and their after-tax earnings without and with the merger are as shown in Table 17.1. 4. To deter firms from combining solely to take advantage of tax loss carryforwards, the Tax Reform Act of 1986 imposed an annual limit on the amount of taxable income against which such losses can be applied. The annual limit is determined by formula and is tied to the value of the loss corporation before the combination. Although not fully eliminating this motive for combination, the act makes it more difficult for firms to justify combinations solely on the basis of tax loss carryforwards. 716 PART 6 Special Topics in Managerial Finance TABLE 17.1 Total Taxes and After-Tax Earnings for Hudson Company Without and With Merger Year 2 3 Total for 3 years $300,000 $300,000 $300,000 $900,000 120,000 120,000 120,000 360,000 $180,000 $180,000 $180,000 $540,000 $900,000 1 Total taxes and after-tax earnings without merger (1) Earnings before taxes (2) Taxes [0.40 (1)] (3) Earnings after taxes [(1) (2)] Total taxes and after-tax earnings with merger (4) Earnings before losses $300,000 $300,000 $300,000 (5) Tax loss carryforward 300,000 150,000 0 450,000 $150,000 $300,000 $450,000 (6) Earnings before taxes [(4) (7) Taxes [0.40 (5)] (6)] (8) Earnings after taxes [(4) $ 0 0 (7)] 60,000 120,000 180,000 $300,000 $240,000 $180,000 $720,000 With the merger the total tax payments are less—$180,000 (total of line 7) versus $360,000 (total of line 2). With the merger the total after-tax earnings are more—$720,000 (total of line 8) versus $540,000 (total of line 3). The merged firm is able to deduct the tax loss over 20 years or until the total tax loss is fully recovered, whichever comes first. In this example, the total tax loss is fully deducted by the end of year 2. Increased Ownership Liquidity The merger of two small firms or of a small and a larger firm may provide the owners of the small firm(s) with greater liquidity. This is due to the higher marketability associated with the shares of larger firms. Instead of holding shares in a small firm that has a very “thin” market, the owners will receive shares that are traded in a broader market and can thus be liquidated more readily. Also, owning shares for which market price quotations are readily available provides owners with a better sense of the value of their holdings. Especially in the case of small, closely held firms, the improved liquidity of ownership obtainable through merger with an acceptable firm may have considerable appeal. Defense Against Takeover Hint In an unfriendly takeover, top management and/or the majo...
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