There are two qualifications to our nol discussion 1

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There are two qualifications to our NOL discussion: 1. Federal tax laws permit firms that experience periods of profit and loss to even things out through loss carryback and carryforward provisions. A firm that has been profitable in the past but has a loss in the current year can get refunds of income taxes paid in the past three years. After that, losses can be carried forward for up to 20 years. Thus, a merger to exploit unused tax shields must offer tax savings over and above what can be accomplished by firms via carryovers. 4 2. The IRS may disallow an acquisition if the principal purpose of the acquisition is to avoid federal tax by acquiring a deduction or credit that would not other- wise be available. UNUSED DEBT CAPACITY Some firms do not use as much debt as they are able. This makes them potential acquisition candidates. Adding debt can provide important tax sav- ings, and many acquisitions are financed with debt. The acquiring company can deduct interest payments on the newly created debt and reduce taxes. SURPLUS FUNDS Another quirk in the tax laws involves surplus funds. Consider a firm that has free cash flow—cash flow available after all taxes have been paid and after all positive 4 The specific tax rules contain a number of complications, particularly when mergers or mergerlike transactions are involved.
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11 net present value projects have been financed. In such a situation, aside from purchasing fixed-income securities, the firm has several ways to spend the free cash flow, including: 1. Paying dividends. 2. Buying back its own shares. 3. Acquiring shares in another firm. We discussed the first two options in Chapter 16. We saw that an extra dividend will increase the income tax paid by some investors. A share repurchase will reduce the taxes paid by shareholders as compared to paying dividends, but this is not a legal option if the sole purpose is to avoid taxes that otherwise would have been paid by shareholders. To avoid these problems, the firm can buy another firm. By doing this, the firm avoids the tax problem associated with paying a dividend. Also, the dividends received from the purchased firm are not taxed in a merger. Reductions in Capital Needs All firms must make investments in working capital and fixed assets to sustain an efficient level of operating activity. A merger may reduce the combined investments needed by the two firms. For example, it may be that Firm A needs to expand its manufacturing facilities whereas Firm B has significant excess capacity. It may be much cheaper for Firm A to buy Firm B than to build from scratch. In addition, acquiring firms may see ways of more effectively managing existing assets. This can occur with a reduction in working capital resulting from more efficient handling of cash, accounts receivable, and inventory. Finally, the acquiring firm may also sell off certain assets that are not needed in the combined firm.
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  • Spring '12
  • Scott
  • Firm, Firm B

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