578 Making Key Strategic Decisions
Tax Savings Corporations in the U.S. pay billions each year in corporate in-
come taxes. M&A activity may create tax savings that would not be possible ab-
sent the transaction. While acquisitions made solely to reduce taxes would be
disallowed, substantial value may result from tax savings in deals initiated for
valid business purposes. We consider the following three ways that tax incen-
tives may motivate acquisition activity:
- Unused operating losses.
- Excess debt capacity.
- Disposition of excess cash.
Operating losses can reduce taxes paid, provided that the firm has operating
profits in the same period to offset. If this is not the case, the operating losses
can be used to claim refunds for taxes paid in the three previous years or car-
ried for ward for 15 years. In all cases, the tax savings are worth less than if
they were earned today due to the time value of money.
Example 4 Consider two firms, A and B, and two possible states of the econ-
omy, boomand bust with the following outcomes:
Firm A Firm B
Boom Bust Boom Bust
Taxable income $1,000 $(500) $(500) $1,000
Taxes (at 40%) (400) 0 0 (400)
Net income $ 600 $(500) $(500) $ 600Notice that for each possible outcome, the firms together pay $400 of
taxes. In this case, operating losses do not reduce taxes for the individual firms.
Now consider the impact of an acquisition of firm B by firm A.
Firm A /B
Boom Bust
Taxable income $500 $500
Taxes (at 40%) (200) (200)
Net income $300 $300The taxes paid have fallen by 50% to $200 under either scenario. This is
incremental cash f low that must be considered when assessing the acquisition’s
impact on value creation. This calculation must be done with two caveats.
Firstly, only cash flows over and above what the independent firms would ulti-
mately save in taxes should be included and secondly, the tax savings cannot be
the main purpose of the acquisition.
Interest payments on corporate debt are tax deductible and can generate
significant tax savings. Basic capital structure theory predicts that firms will
issue debt until its additional tax benefits are offset by the increased likelihood