Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

25. Mergers and
    Acquisitions

(^876) © The McGraw−Hill
Companies, 2002
Technology transfers are another reason for vertical integration. Very frequently, a
company will decide that the cheapest—and fastest—way to acquire another firm’s
technological skills is to simply buy the firm. For obvious reasons, this rationale is par-
ticularly common in high-tech industries. A good example is the acquisition of Vermeer
by Microsoft that we mentioned earlier.
Complementary Resources Some firms acquire others to make better use of exist-
ing resources or to provide the missing ingredient for success. Think of a ski equipment
store that could merge with a tennis equipment store to produce more even sales over
both the winter and summer seasons, and thereby better use store capacity.
Lower Taxes
Tax gains are a powerful incentive for some acquisitions. The possible tax gains from an
acquisition include the following:

1. The use of tax losses


2. The use of unused debt capacity


3. The use of surplus funds


4. The ability to write up the value of depreciable assets

Net Operating Losses Firms that lose money on a pretax basis will not pay taxes.

Such firms can end up with tax losses they cannot use. These tax losses are referred to

as net operating losses (NOL).

A firm with net operating losses may be an attractive merger partner for a firm with

significant tax liabilities. Absent any other effects, the combined firm will have a lower

tax bill than the two firms considered separately. This is a good example of how a firm

can be more valuable merged than standing alone.

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 carry-back and carry-forward 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 15 years. Thus, a merger to exploit unused tax shields must offer tax
   savings over and above what can be accomplished by firms via carry-overs.^6


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 otherwise 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

savings, 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 net present value projects have been financed. In such a situation, aside from

852 PART EIGHT Topics in Corporate Finance

(^6) Under the 1986 Tax Reform Act, a corporation’s ability to carry forward net operating losses (and other tax
credits) is limited when more than 50 percent of the stock changes hands over a three-year period.