ACC 424 Financial Reporting II Lecture 10 Supplementary slides on Megafoods case

2 Megafoods case What kind of business combination does each strategy involve? –Acquire the property for $400,000 cash Sale of assets Step-up in assets basis Taxable for George Foods Inc –Exchange Megafoods stock worth $375,000 for 100% of George Foods Inc stock Tax-free stock acquisition No step up in assets Limited transfer of NOL Not taxable for Mr. & Mrs. George

3 Megafoods case Megafoods’ preferred strategy Taxable asset acquisition strategy net cost Cash outlay $400,000 Less: PV of Depreciation shield Step-up to $320,000 that can be recovered on a straight-line basis over 31.5 years. Annual depn = $320,000/31.5=$10,159 After-tax depn shield = 10,159 .34 =$3,454 PV = 3454  PVFA(10%,31)+1727  PVF(10%,32) = 2,790   = 32,822 Net Cost$367,178

4 Megafoods case Megafoods’ preferred strategy Net cost of tax-free stock acquisition strategy Market value of stock $375,000 Less: PV of Depreciation shield After-tax depn shield = 3,800 .34 =$1,292 Present value = 1,292  PVFA(10%,28)  PVF(10%,28.5) = 1,292  .066 = $12,067 Less: PV of NOL Annual limitation under s.382 ($  prescribed long-term tax exempt rate) = 375,000 .07 = $26,250 Tax benefits years 1&2=.34  $26,250=$8,925 Tax benefit 3rd year =.34  22,500=$7,650 Present value = 8,925  ,650 .751 = 21,239 33,306 Net cost $341,694

5 Megafoods case Georges’ preferred strategy Net benefit of taxable asset acquisition strategy Cash received by George Foods Inc.$400,000 Less: income tax on capital gain Cash $400,000 Less: building’s bv = $3,800  28.5  108,300  land bv 16,700 $125,000 Capital gain $275,000 Less: NOL 75,000 Taxable capital gain $200,000 Tax on capital gain.28 of $200,000 56,000 Net cash received by George Foods Inc$344,000 Net distribution possible to shareholders $344,000 Liquidation distribution$344,000 Less: Mr. & Mrs. George’s basis 200,000 Capital gain assuming liquidation$144,000 Tax at 28% 40,320 Net liquidation benefit received by the Georges$303,680

6 Megafoods case Georges’ preferred strategy Net benefit of tax-free stock acquisition strategy Market value of shares$375,000 Less: Tax if they liquidate basis $200,000 capital gain 175,000 49,000 Net liquidation benefit$326,000 This strategy is preferred by both the Georges & Megafoods Inc. Its is better for –Megafoods by $367, ,694 = $25,484 –the Georges by $326, ,680 = 22,320 The total benefit is $47,804 How can that be? Where does the extra $47,804 come from?

7 Megafoods case Source of stock acquisition advantage The answer is the IRS loses $47,804 Advantages of stock acquisition –Limited transfer of NOL$21,239 Disadvantage of asset purchase –Corporate tax on gain on sale of assets (after deducting NOL) 56,000 $77,239 Less advantage of asset purchase –Step-up - difference in PV of tax shields ($32,822-12,067)$20,755 $56,484 Less higher personal capital gains tax ($49,000-40,320)$ 8,680 Net advantage to stock acquisition $47,804

8 Megafoods case Minimum tax-free deal The minimum Megafoods could have offered the Georges in a tax-free deal depends on the best deal any other purchasers might offer If we assume the best deal would be the taxable offer (i.e., $303,680 after taxes) we can calculate the minimum stock value Megafoods could have offered and still consumated the deal The formula for the benefits of the tax-free deal is: Stock value-.28(stock value-200,000) = $303, stock value = $247,680 stock value = $344,000

9 Megafoods case Minimum tax-free deal If Megafoods offered $344,000 they could have saved $375, ,000= $31,000 (before NOL effect) Less reduction in PV of NOL tax effect NOL deduction $344,00 .07=24,080 for 3 years and $75,000-24,080  3 =$2,760 for year 4 PV of tax effect of NOL deduction.34  24,080  PVFA(10%,3)+.34  2,760  PVF(10%,4) = $8,187  .68301=$21,001 Change in NOL tax effect PV Previous effect - new effect = $21,239 - $21,000 = $239 Net saving = $31, = $30,761