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Chapter 5: Q.1 (page 649)

The Clark Corporation desires to expand. It is considering a cash purchase of Kent Enterprises for \(3 million. Kent has a \)700,000 tax loss carryforward that could be used immediately by the Clark Corporation, which is paying taxes at the rate of 30 percent. Kent will provide $420,000 per year in cash flow (aftertax income plus depreciation) for the next 20 years. If the Clark Corporation has a cost of capital of 13 percent, should the merger be undertaken?

Short Answer

Expert verified

Answer

Yes, the merger should be undertaken

Step by step solution

01

Step-by-Step-SolutionStep 1: Calculation of net cash outflows and cash inflows

Net cash outflows and inflows are calculated as follows:

Cash outflow

Purchase price

$3,000,000

Less: Tax shield benefit from tax ($700,000 x 30%)

210,000

Net cash outflow

$2,790,000

Cash inflow

Present value of $420,000 x 7.025 (Appendix D)

(n = 20, i = 13%)

$2,950,500

Total present value of cash inflow

$2,950,200

02

Calculation of net present value

Net present value is calculated as follows:

Total present value of cash inflow

$2,950,200

Net cash outflow

2,790,000

Net present value

$160,500

Thus, the net present value equals $160,500. As it is positive, merger should be undertaken.

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Most popular questions from this chapter

Explain the functions of the following agencies:

Overseas Private Investment Corporation (OPIC)

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Explain how exports and imports tend to influence the value of a currency

What procedures would you recommend for a multinational company in studying exposure to political risk? What actual strategies can be used to guard against such risk?

Assume the following financial data for Rembrandt Paint Co. and Picasso Art Supplies:

Rembrandt

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Picasso Art

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Total earnings ........................................................... \(1,200,000 \)3,600,000

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Price-earnings ratio (P/E) ......................................... 243 323

Market price per share.............................................. \(48 \)48

a.If all the shares of Rembrandt Paint Co. are exchanged for those of Picasso

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per share be for Picasso Art Supplies? Use an approach similar to that in

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b.Explain why the earnings per share of Picasso Art Supplies changed.

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