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Chapter 5: Q1BP (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

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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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