Computation of present value of cash flows; untaxed acquisition, no change in tax basis of assets. The balance sheet of Lynch Company shows net assets of $100,000 and shareholders’ equity of $100,000. The assets are all depreciable assets with remaining lives of 20 years. The income statement for the year shows revenues of $700,000, depreciation of $50,000 (=$1,000,000 ÷20 years), no other expenses, income taxes of $260,000 (40% of pretax income of $650,000), and net income of $390,000.
Bages Company is considering purchasing all of the stock of Lynch Company. It is willing to pay an amount equal to the present value of the cash flows from operations for the next 20 years discounted at a rate of 10% per year.
The transaction will be a tax-free exchange; that is, after the purchase, the tax basis of the assets of Lynch Company will remain unchanged so that depreciation charges will remain at $50,000 per year and income taxes will remain at $260,000 per year. Revenues will be $700,000 per year for the next 20 years.
a. Compute the annual cash flows produced by Lynch Company.
b. Compute the maximum amount Bages Company should be willing to pay.