Strategic Business Tax Planning, 2nd Edition Solution Manual

Strategic Business Tax Planning, 2nd Edition BY John E. Karayan

STRATEGIC BUSINESS TAX PLANNING Chapter 1 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

You are the Chief Executive Officer of a New Orleans-based company which grosses $30 million a year. Entirely through a Web site, the company sells exotic breakfast cereals which are imported from the Cayman Islands, the Netherlands Antilles, and the Cook Islands, where the grains are indigenous. On your way to work, you hear that the U.S. Congress is considering passing legislation imposing a 3% excise tax on companies which trade with tax havens. How could you most efficiently find out whether the law would affect your company?

2.

As an executive for a major telecommunications firm, you are looking at a choice between two capital investments over the next five years. The first is developing new hardware and software for TV Internet access. Although the payoffs are unknown, this option is made more attractive by a 20% U.S. income tax credit. The second option is simply replacing your existing equipment at major telecommunication centers across the United States. How should you factor taxes into weighing these alternatives?

3.

One of the software companies you have invested in just issued the following press release: “We are delighted to announce that we have begun negotiations with our closest competitor on a possible merger, which would be tax free under United States Code Section 368. Because the discussions have just started, we can give no other information at this time.”

What sources would be best for helping you find out whether this would be good for you?

4.

Your best friend’s parents, who retired after selling their business for $5 million last year, so enjoyed their subsequent vacations to Vancouver, British Columbia; Santiago, Chile; and Paris, Texas that they have decided to relocate to one of them. Because your best friend is their only child, and the sole beneficiary under their will, would her parent’s decision on where to move affect her inheritance?

5.

Your sister is thinking about starting a Web-based business selling specialty teas to upper middle class American women who are working outside the home for compensation. If the business is to start up in three months, what key decisions will your sister face during that period, and how might taxes impact them?

6.

You work for a family-owned business located in Coos Bay, Oregon, which manufactures prefabricated metal structures. The owner’s granddaughter has just started college at McGill University in Quebec, and he has promised to pay half of her costs provided she majors in engineering and works for the business after she graduates. Over lunch, he asks you to find out whether he should pay his half from his personal accounts or put her on the payroll. What taxes should be considered in making this decision?

2

PROBLEMS 1.

Refer to CONCEPT APPLICATION question 1. What are the pros and cons of looking into the issues with a Web search rather than contacting a tax professional?

2.

Refer to CONCEPT APPLICATION question 4. How would your analysis change were you to find out that that although the parents are both in good health, they are 90years old? What if one were terminally ill?

3.

Refer to CONCEPT APPLICATION question 5. How would your answer change if your sister is willing to move anywhere in the world?

4.

Refer to CONCEPT APPLICATION question 6. How would your answer change if the business were located in Australia? France?

3

MINICASE 1: PET PUBLICATIONS, INC. “Dog Delight must go” declared Mary Gold, Chief Executive Officer (and majority shareholder) of publicly traded PET Publications, Inc., at the quarterly Board of Directors meeting last night.

PPI is the industry-leading publisher of electronic magazines for pet owners, and you were at the meeting to brief the Board members on sales trends.

“Our shareholders expect a 20% return on sales. All of our titles – Bird World, Feline Fancy, and Reptile World – clear the 20% hurdle. But Dog Delight only makes 10%. Sure, it generates $2 million in net operating losses per year, which partly offsets the $20 millions of taxable income from the rest of the organization. I think we should sell it to Animal Publications.”

Animal Publications is your major rival, comparable in sales and assets ($30 million and $150 million, respectively) but consisting of 20 smaller publications which did not have the brand recognition of PPI’s four publications. Data on public 10K reports indicates that the rival was paying taxes at a 34% rate.

As sales manager, you pointed out to the Board that they should consider that: ▪

Feline Fancy was the “flagship” publication with a circulation double any of the other three magazines.

▪

Advertising revenues have declined significantly over the last three years.

▪

If the magazine is sold, it will sell for about a $20 million profit.

If you are asked to prepare a report to the Board on this subject, what tax issues would you need to discuss in it?

4

MINICASE 2: BENOIT PHARMACEUTICALS You work for Benoit Pharmaceuticals, Inc., which was formed in 1990 by Richard Benoit, PhD. Formerly a research scientist with a major pharmaceutical, he decided to strike out on his own and still owns 100% of the stock of the Princeton, New Jersey, based manufacturer. The firm has been hugely successful by manufacturing aspirin and acetaminophen substitutes.

Throughout all of his years of school and work, Dr. Benoit always aspired to a higher calling.

Put simply, he always wanted to be a cowboy. Three years ago, he acted on it and bought an operating cattle ranch located on 1,000 acres of land in Ontario, Canada. Blackstone has always just about broken even cash flow with the business.

Anne, who has been married to John for 25 years, is thinking about surprising him on his 50th birthday in December with a four-week trip to visit cattle farms throughout Europe. The plan is to land in London, spend a few days there getting acclimated and enjoying the place, and then spend a day visiting a Hereford cattle farm in Hampshire while driving up to Glasgow. There, they will set aside a whole day to visit an Angus cattle farm and another for a ranch specializing in the Aberdeen breed. After spending a week in Scotland, they will fly to Paris, where after three days they will travel to a Holstein cattle ranch in Holland, a Limousine ranch in the South of France, and a Jersey ranch in the Isle of Guernsey. The last week will be spent in Switzerland, with two days set aside for visits to farms specializing in the Simmental and Brown breeds.

To get the most out of the vacation, Anne—a highly successful entertainment lawyer—plans to write a screenplay out of their experience, and has been floating the idea around her various contacts under the working title An American Cowboy in Paris.

How might tax benefits reduce the actual costs of the four-week vacation?

5

Commented [h1]: Who is Blackstone?

Commented [h2]: Or Richard, see p.1

MINICASE 3: Build a Better Battery Galadriel Elvin, a wealthy entrepreneur, was returning home after taking the eldest of her three children to start college on the other side of the country when she noticed that the person sitting next to her in the first-class cabin was absentmindedly fiddling with a pink substance. When she asked about it, Bill Halfacre explained that he had developed it because he was spending a small fortune on batteries for his young children’s toys. Simply dipping regular alkaline batteries in the substance for an hour had proven to more than double the effective life of the batteries.

When Galadriel mentioned that this was a great idea, Bill replied that he was a bit depressed because he had been trying to connect with someone who could help him develop and market the product, but had been unsuccessful. Galadriel encouraged him, and discovered that he had lived a varied and interesting life. He had earned several degrees in chemistry, but had spent all his time since graduating surfing throughout the world, and tinkering with various inventions. (He had inherited enough money that he had not had to work since he finished school five years ago, but the money was running out.)

By the time the plane landed, Galadriel and Bill had set a time to meet with Galadriel's lawyer, Elsa Treebeard, to discuss a venture to market Bill's products. They also invited one of Galadriel's colleagues, Jim Pippin, to attend the meeting. Jim had worked with Galadriel on several occasions: he makes a lot, but keeps very little, money. He is a marketing whiz who has strong connections to several distributors to large office supply outlets. Galadriel's concern with Jim has always been that he plays things a bit fast and loose.

At the meeting, the group developed projections of profits and losses for the first five years of the business. The expectation is that annual losses will range from $100,000 to $200,000 over these five years, with break-even in about Year 5. The business will be capitalized with about $200,000 in cash, along with computers, equipment, furniture, and fixtures (fair market value of $100,000 and basis of $25,000) contributed by Galadriel. Bill will contribute the patent at an agreed value of $150,000. Jim has nothing to contribute but time. He will receive a 25% interest for contributing all of his time for a year to get the business going. Thereafter, he will be compensated based on sales and profits. Elsa believes they will be able to borrow $200,000 initially and perhaps an additional $100,000 per year during the development period. The money will be used for working capital and manufacturing equipment. They feel that they may be able to attract new investors once some of the initial work has been completed.

Galadriel thinks Jim brings some needed talents to the venture, but she is very uneasy about being exposed to liabilities that he might create. Bill says he has nothing to lose so the association with Jim does not concern him. Galadriel has about $500,000 in income each year.

Bill's income is about $25,000 a year and Jim has earned anywhere from $0 to $200,000 annually over the last few years.

How might taxes impact the results of the major strategic decisions faced by the three venturers as they start up the business?

6

STRATEGIC BUSINESS TAX PLANNING Chapter 2 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

You are the CEO for a company that makes a line of breakfast cereals. It has come to your attention that a small frozen foods manufacturing company is for sale which has substantial tax benefits. What questions would you want to ask before proceeding with an acquisition?

2.

Currently your company, a manufacturer of toiletries, manufacturers in the United States for a worldwide market. You are considering setting up a manufacturing subsidiary in the People’s Republic of China (PRC) because the current tax rate is 15%. What other factors should you consider?

3.

One of your major distribution centers, located out of state, is in dire need of replacement. You can rebuild it, or buy a new one, either in the same state or in another one. You have also been offered the chance to trade the old distribution center for some land where you could construct the new distribution center. Discuss each option, from a tax and nontax standpoint.

4.

As an executive for a major telecommunications firm, you are looking at a choice between two capital investments over the next five years. The first is developing new hardware and software for TV Internet access. Although the payoffs are unknown, this option is made more attractive by the 20% tax credit for federal tax purposes. The second option is simply replacing your existing equipment at major telecommunication centers across the United States. What are the tax and nontax tradeoffs?

5.

One of your top executives may be lured away by a competitor firm. Her current salary is $300,000. You are contemplating giving her stock options, which can be exercised at $5 per share (the price at which the stock is currently trading), for 100,000 shares. The firm currently has one million shares outstanding and after-tax income of $2 million.

Assume that the options are tax-advantaged to both the firm and the executive. What are the nonfinancial and economic value added (EVA) tradeoffs?

6.

Your firm’s manufacturing is done in your plant in Mexico, which then ships the parts to your Texas plant for final assembly. For U.S. tax purposes, the Mexican plant is not taxed until it sends a cash dividend back to the parent. A transfer price is set for the interplant shipments, which is sales revenue taxable (by Mexico) to the Mexican plant, and deductible, as cost of goods sold, by the U.S. plant on its U.S. return. The Mexican tax rate is 25% and the U.S. rate is 34%. Corporate headquarters would like to set the transfer price in a tax-minimizing fashion, i.e., a high price), but since the transfer price would also be used for financial statement and internal reporting purposes, they are concerned about nontax tradeoffs. Discuss the nontax tradeoffs.

7.

You work for an investment banking firm, and one of your hi-tech clients is about to have an initial public offering (IP0) of common stocks and bonds. Because of riskiness of the firm, the bonds would have to pay 9%. The firm is in a net operating loss (NOL) tax position now, but in two years expects to transit (permanently) into the 34% bracket.

Both pension funds (which are tax free) and taxable investors have expressed interest in the IPO. Discuss the tax/nontax tradeoffs about which you would advise your client on in determining the relative mixture of stocks and bonds to float.

2

PROBLEMS 1.

2.

3.

Refer to CONCEPT APPLICATION question 1. Suppose the frozen food company has $1.5 million in tax benefits, which your company can use evenly through the next 10 years. Assuming your cost of capital is 8%, what is the most your company should be willing to pay for the tax benefits? (See present value tables in the Appendix). Should you be able to negotiate the price lower?

Refer to CONCEPT APPLICATION question 3. Assume that the cost of a factory is $20 million, regardless of whether it is new or rebuilt. Assume that 30% of the cost is land, and 20% building. The remainder is seven-year MACRS equipment. Assuming the firm’s cost of capital is 10%, what is the time value of tax depreciation over the first two years?

Refer to CONCEPT APPLICATION question 4. Assume R&D qualifying for the federal tax credit is $5 million. How would your answer change if, due to an expiring NOL carryforward this year, the firm can only use one half of the credit this year (assume 10% cost of capital)? How would your answer change if, instead, 50% of the R&D was “soft costs,” with the other half for R&D equipment?

3

Commented [h1]: Is there an appendix?

Commented [h2]: Spell out MACRS

MINICASE 1: PET PUBLICATIONS, INC. “Dog Delight must go” declared Marv Gold, owner and majority shareholder of the publicly traded PPI. PET Publications, Inc. was the industry leading publisher of magazines for pet owners.

“Our shareholders expect a 20% return on sales. All of our books – Bird World, Feline Fancy, Reptile World – clear the 20% hurdle. But Dog Delight only makes 10%. Sure, it generates $2 million in new operating losses per year, which partly offsets the $20 millions of taxable income from the rest of the organization. I think we should sell it to Animal Publications.”

Animal Publications was their major rival in the industry. It was comparable in sales and assets ($30 million and $150 million, respectively) but consisted of 20 smaller publications which did not have the brand recognition of PPI’s four publications. Data on public 10K reports indicated the rival was paying taxes at a 34% rate.

As Chief Financial Officer, you decided to gather more facts before moving forward with the sale: ▪

Feline Fancy was the “flagship” publication with a circulation double any of the other three magazines.

▪

Advertising revenues have declined significantly over the last three years.

▪

If the magazine is sold, it will sell for $30 million with a tax basis of $10 million in assets and a $20 million taxable gain will result.

▪

If the magazine is spun off into a separate subsidiary, it can be operated or sold. If retained, PPI earnings per share (EPS) would go up to $50, while EPS for the subsidiary would be $20.

If the subsidiary is sold, there would be a capital gain of $20 million.

What would you recommend to Mr. Gold?

4

MINICASE 2: BENOIT PHARMACEUTICALS Benoit Pharmaceuticals, Inc. was formed in 1990 by Richard Benoit, PhD. Formerly a research scientist with a major pharmaceutical, he decided to strike out on his own. He owned 100% of the stock of the Princeton, New Jersey based manufacturer. The firm had been hugely successful by manufacturing aspirin and acetaminophen products.

Flush with cash, Benoit felt that it was the time to take a chance on a product that might be a home run. Two researchers at Johns Hopkins had been doing promising work in oncology, and might be able to develop some effective cancer treatments. He felt that he could hire them away, set up an R&D facility, and within five years get back 10 times his investment. The scientists plus support staff would earn $500,000 per year, annual operating costs would be another $100,000, and an up-front investment of $1 million in lab equipment would be necessary. His tax consultant estimated that a $400,000 tax benefit would occur in the first year, with $200,000 in tax benefits occurring in each of the next five years. The tax benefits would come primarily from a tax credit for research and development. The investment was risky, with an industry average success rate of 50% in oncological products.

Although there was enough free cash flow to finance the investment internally, Benoit preferred to finance it with external financing. Borrowing would be at 12%. Or he could spin the R&D operation off into a separate subsidiary, issuing stock to venture capitalists. The venture capitalists would expect an eventual return of 200%. If the subsidiary were formed as a partnership, some of the tax benefits might flow through to the venture capitalists.

What would you recommend?

5

MINICASE 3: TOYZ-TO-KIDZ “It’s amazing, really. No annual report this year, or ever” said Mike Jefferson. As a partner in a regional office in a Big 4 firm, it took a lot to amaze him.

Jennifer Cho liked the challenge. She had been an audit manager for their client, Toyz-toKidz, for five years now, and wanted to be business adviser to every transaction they entered.

The target firm was called Actionroids, and its sole product was an action robot doll which (based on a TV series) was selling about 10 million units a year. The reclusive owner, Aris Simkis, owned 100% of the stock of the corporation. Conservative by nature, Simkis had never borrowed to finance the operation, and there had never been the need for formal financial statements.

“What do we have to work with?” inquired Jennifer.

“Basically, a corporate tax return. He can’t seem to find the trial balance and other books – he claims his long time accountant and friend, Sid Levin, left no indication where they were before he died last week. Our attest and valuation team did vouch for the existence of the assets.

The fair market value (FMV) of assets, including goodwill, is about $75 million. Debts are mortgages, some short-term liabilities to suppliers and employees which amount to $60 million.

Since comparable toy companies sell for 15 times (net financial) earnings, Toyz-to Kidz would like to get a better fix on value by reconstructing financial earnings”

6

Cho gathered the following: 2006 Tax Year ($Thousands) Sales Cost of goods sold Gross profit Dividend income Advertising expense Interest expense Selling, general, and administrative Bad debt expense Federal taxable income Gross tax Credits Net tax due with return

$ 98,500 60,000 38,500 1,000 5,000 15,000 6,000 5,000 8,500 2,890 2,500 $ 390

Commented [h3]: Verify it’s correct

Commented [h4]: Verify it’s correct

From other parts of the return you determined: ▪

Cost of goods sold included $4 million of depreciation expense. The entire factory had been rebuilt in January 2006 for $60 million with $30 million allocated to the building, and the remainder was equipment depreciated as seven year MACRS property. Realistically, the economic life of the equipment was closer to 10 years.

▪

Dividend income was from holdings of IBM stock, and was net of the dividends received deduction.

▪

Bad debts were from sales to wholesale customers. The firm’s attest team felt that each year, a good estimate of bad debts was 10% of sales.

▪

Interest expense included $1,000 of expensing of loan fees on the 30-year loan for the new building. No one was sure of the tax or book treatment of this item.

What would Toyz-to-Kidz value be based on earnings?

7

Commented [h5]: Spell out MACRs

STRATEGIC BUSINESS TAX PLANNING Chapter 3 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

You are working as a marketing manager for a large corporation, and you have some marketing ideas related to the Internet, which are not of interest to your firm. Accordingly, you plan on starting your own weekend business as an internet marketing consultant. You want to do this on your own, and you foresee little outside capital needs in the near future. Should you continue to operate as a sole proprietor?

2.

While working full-time on your MBA, you befriended a biology grad student who has convinced you that he can develop the technology for rapidly identifying genes in DNA. He believes that starting your own company, patenting the idea, and selling it to biotech firms could net millions in revenues. However, the hardware and software developments would be $100,000, which is about $100,000 more than either one of you have saved. Discuss the merits of sources of external funding/entity choice.

3.

Give examples of where the principles of SAVANT might with each other conflict in the entity choice decision.

4.

If an enterprise expects net operating losses in the early years, is it always better to utilize a flow-through entity? Why or why not?

5.

What entity types do you suppose wealthy individuals invest in? What tax versus nontax tradeoffs do you think they face, and how could they manage such tradeoffs?

2

Problems 1.

Refer to Concept Application 1. Assume the marketing manager is your client. The state you live in allows one-person corporations and Limited Liability Companies. Consultation with the client reveals the following: Personal Net assets: $500,000; net disposable income/year: $50,000; liquid assets: $100,000 Business Up-front cash needed: $50,000 Cash needed to cover operating costs per year (Programmers, graphics designers, advertisements): $20,000 Estimated Revenues: 20,000 per year, with 20% growth thereafter.

Redo your analysis based on these facts. Assume your client has a required pretax rate of return of 6%, and that he is in the 35% tax bracket.

2.

You are the in-charge accountant for an attestation engagement when a tax issue arises. Your S corporation client, which previously had positive taxable income, has incurred a $1 million new operating losses. The two shareholders each have a tax basis in their stock of $300,000.

What will happen to the “excess” tax losses? How might you advise your client to utilize these losses? How would this advice fit with the SAVANT concept?

3.

One of your clients is a plastic surgeon in a highly lucrative practice with four other plastic surgeons. Together, the net income for the practice is $20 million. Assume that taxable income is about one half of this amount, that the firm (a corporation) has not paid dividends in its five-year history, and the surgeons have paid themselves salaries of $100,000 per year (each). What tax problems might arise? How could they be remedied?

3

MINICASE A friend of yours is a biotech scientist who is developing a method of cloning certain antibodies. You have estimated that if the proceeds can be patented, it would be worth $10 million per year in royalties if licensed to major firms. The cost of finishing the research is $5 million, one-half of which is for equipment and one-half scientists’ salaries. You can finance the deal yourself by bank borrowing at 15%, or, acting through a broker, find wealthy investors would put up equity. Due to risk considerations, they would probably expect 3:1 returns. Some of these investors would probably want some management control. You estimate that there is an 80% probability of success, with two years of R&D necessary before revenues would commence. What legal entity choice might be appropriate?

How should it be structured? How might it evolve over time?

4

COMPREHENSIVE STRATEGY TAX MANAGEMENT CASES: Dataserve and HIP-HAHP RAPPAZ Note to Students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

5

HIP-HAHP RAPPAZ Sid Lewis looked imploringly at his counterpart across the table. Kathy Rourke’s body language was clear: forming a partnership was not negotiable. As business manager for Way 2 Kul, her job was to ensure that the successful musician’s interest was protected. The problem was that Lewis’ client, Peace T, was apparently unmovable on the idea of forming a corporation. Both had great success as rappers, but felt that by forming a recording duo record sales and concert appearances would more than double. The name of the venture (Hip-Hahp Rappaz) had been agreed upon, as had the recording agreement. Kul figured to be in a low tax bracket. Since he had an expiring new operating losses (from an unrelated business), of $1 million, he would not be in a taxpaying situation and preferred the venture income to be taxed to him in the early years. Peace T is independently wealthy, but Kul is not; Kul does not want any personal liability beyond the entity level.

Peace T figured to be in the top tax bracket, but thought the venture could spread its income between the two singers in order to minimize taxes. A total of $3 million of external financing was needed to finance the operation, which would be used to finance operating expenses and the purchase of the recording studio (land, building, and equipment). Both agreed that they wanted to take out all excess cash for personal living expenses each year. The financing would come from bank loans and other equity capital raised. The equity capital would be raised at the beginning of Year 2. Under Peace T’s plan, 1,000 shares of stock would be issued to investors. Under Kul’s plan, the same number of “certificate of participation” (partnership interests) would be sold. In either case, there would be a private placement to a select group of wealthy investors, and investors would have restrictions on (if any) management or voting rights. Both are considering whether to appoint a manager for the entity.

The pro forma financial statements are attached. Note that under corporate (flow-through Entity) form, all earnings would be paid out as dividends (distributions). Retained earnings are shown before any taxes or distributions. Discuss the tax and nontax merits of using various entities for this business, using the attached data. Assume each singer has an after-tax discount rate of 6%.

6

Hip- Ha hp PRO FORM A STATEM ENT OF OPERATIONS 2004 Re ve nue s: La b e l Sa le s C o nc e rt Re ve nue Ro ya lty Inc o m e Tota l Re ve nue s Cost of Sa le s

2005

2006

$15,050,000 2,621,000 0 17,671,000 13,463,000

$15,953,000 2,778,260 2,366,000 21,097,260 14,001,520

$16,750,650 3,195,000 2,720,900 22,666,550 14,841,611

4,208,000

7,095,740

7,824,939

2,190,000 2,018,000

2,365,200 4,730,540

2,601,720 5,223,219

Ope ra ting Expe nse s: Fie ld Pro m o tio n G e ne ra l Ad m inistra tio n Sa le s Ad m inistra tio n

176,000 209,000 810,000

190,080 225,720 874,800

209,088 248,292 962,280

Pro visio n fo r Ba d De b ts De p re c ia tio n Exp e nse

278,700 39,333

125,548 43,667

127,173 47,000

3,450 5,600

3,450 5,600

3,450 5,600

60,000 150,000 150,000 1,882,083 135,917

60,000 187,500 187,500 1,903,865 2,826,675

60,000 234,375 234,375 2,131,633 3,091,586

Gross Profit Ad ve rtising a nd Pro m o tio n Contribution to Ove rhe a d

Am o rtiza tio n o f Sta rt-up C o sts Am o rtiza tio n o f O g a niza tio n C o sts Ke y-m a n Life Insura nc e Pre m ium s C o m p e nsa tio n - Pe a c e T C o m p e nsa tio n - Wa y 2 Kul Tota l Ope ra ting Expe nse s Ne t Ope ra ting Inc ome Othe r Inc ome : Inte re st a nd O the r Inc o m e Inte re st Exp e nse , ne t Tota l Othe r Inc ome (Expe nse ) Inc ome Be fore Inc ome Ta xe s

388,000 -265,847

403,520 -58,228

605,280 -52,868

122,153 $258,070

345,292 $3,171,967

552,412 $3,643,998

Pro visio n fo r Inc o m e Ta xe s Inc ome Afte r Inc ome Ta xe s

$108,144 $149,926

$1,098,869 $2,073,098

$1,259,359 $2,384,638

Inc ome Be fore Inc ome Ta xe s Book/ Ta x Diffe re nc e s: De p re c ia tio n Am o rtiza tio n o f Sta rt-up C o sts Am o rtiza tio n o f O rg a niza tio n C o sts Ke y-M a n Life Insura nc e Pre m ium s Ba d De b ts Pro visio n Pro je c te d Ac tua l Write -o ffs Tota l Book/ Ta x Diffe re nc e s Ta xa ble Inc ome C o rp o ra te Ta x Pa ya b le De fe rre d Inc o m e Ta x

$258,070

$3,171,967

$3,643,998

-53,702 -10,350 -16,800 60,000 278,700 -30,100 227,748 $485,818 153,428 ($45,284)

-105,147 -10,350 -16,800 60,000 125,548 -31,906 21,345 $3,193,312 1,073,976 $24,893

-67,480 -10,350 -16,800 60,000 127,173 -33,501 59,042 $3,703,039 1,247,283 $12,076

7

Hip_ha hp Ra ppa PRO FORMA STATEMENT OF OPERATIONS 2004 Revenues: La b e l Sa le s C o nc e rt Re ve nue Ro ya lty Inc o m e Tota l Revenues Cost of Sa les

2005

2006

$15,050,000 2,621,000 0 17,671,000 13,463,000

$15,953,000 2,778,260 2,366,000 21,097,260 14,001,520

$16,750,650 3,195,000 2,720,900 22,666,550 14,841,611

4,208,000

7,095,740

7,824,939

2,190,000 2,018,000

2,365,200 4,730,540

2,601,720 5,223,219

Opera ting Expenses: Fie ld Pro m o tio n G e ne ra l Ad m inistra tio n Sa le s Ad m inistra tio n

176,000 209,000 810,000

190,080 225,720 874,800

209,088 248,292 962,280

Pro visio n fo r Ba d De b ts De p re c ia tio n Exp e nse

278,700 39,333

125,548 43,667

127,173 47,000

3,450 5,600

3,450 5,600

3,450 5,600

60,000 150,000 150,000 1,882,083 135,917

60,000 187,500 187,500 1,903,865 2,826,675

60,000 234,375 234,375 2,131,633 3,091,586

Gross Profit Ad ve rtising a nd Pro m o tio n Contribution to Overhea d

Am o rtiza tio n o f Sta rt-up C o sts Am o rtiza tio n o f O g a niza tio n C o sts Ke y-m a n Life Insura nc e Pre m ium s C o m p e nsa tio n - Pe a c e T C o m p e nsa tio n - Wa y 2 Kul Tota l Opera ting Expenses Net Opera ting Income Other Income: Inte re st a nd O the r Inc o m e Inte re st Exp e nse , ne t Tota l Other Income (Expense) Income Before Income Ta xes

388,000 -265,847

403,520 -58,228

605,280 -52,868

122,153 $258,070

345,292 $3,171,967

552,412 $3,643,998

Pro visio n fo r Inc o m e Ta xe s Income After Income Ta xes

$108,144 $149,926

$1,098,869 $2,073,098

$1,259,359 $2,384,638

Income Before Income Ta xes Book/ Ta x Differences:

$258,070

$3,171,967

$3,643,998

*Calculated as a per cent of label sales ** $3m raised at beginning of 2005 used to pay off long-term *** Reflects earnings paid out to owners

Commented [h1]: What does these notes refer to?

8

Hip- Ha hp PARTNERSHIP ALLOCATIONS: WAY 2 KUL 50%

PEACE T 50%

Ye a r 2004 Ne t Inc o m e / <Lo ss> Inte re st Inc o m e Inte re st Exp e nse G ua ra nte e d Pa ym e nts Distrib utio ns

331,832 194,000 -132,924 150,000 50,000

331,832 194,000 -132,924 150,000 50,000

Ba sis:

942,909

942,909

WAY 2 KUL 25%

PEACE T 25%

INVESTORS 50%

Ye a r 2005 Ne t Inc o m e / <Lo ss> Inte re st Inc o m e Inte re st Exp e nse G ua ra nte e d Pa ym e nts Distrib utio ns

805,755 100,880 -14,557 187,500 500,000

805,755 100,880 -14,557 187,500 500,000

1,611,510 201,760 -29,114 0 1,000,000

Ba sis:

1,147,487

1,147,487

3,784,156

Ne t Inc o m e / <Lo ss> Inte re st Inc o m e Inte re st Exp e nse G ua ra nte e d Pa ym e nts Distrib utio ns

904,844 151,320 -13,217 234,375 1,000,000

904,844 151,320 -13,217 234,375 1,000,000

1,809,689 302,640 -26,434 0 2,000,000

Ye a r 2006

9

Interest and Other Income Interest Expense, net

388,000 -265,847

403,520 -58,228

122,153 $258,070

345,292 $3,171,967

552,412 $3,643,998

Provision for Income Taxes Income After Income Taxes

$108,144 $149,926

$1,098,869 $2,073,098

$1,259,359 $2,384,638

Income Before Income Taxes Book/Tax Differences: Depreciation Amortization of Start-up Costs

$258,070

$3,171,967

$3,643,998

-53,702 -10,350

-105,147 -10,350

Adjusted Tax Bases: -67,480 Land -10,350 Studio

-16,800 60,000 278,700 -30,100

-16,800 60,000 125,548 -31,906

-16,800 Recording Equipment 60,000 Offfice Equipment 127,173 -33,501

Total Book/Tax Differences Taxable Income Corporate Tax Payable

227,748 $485,818 153,428

21,345 $3,193,312 1,073,976

59,042 $3,703,039 1,247,283

Deferred Income Tax

($45,284)

$24,893

$12,076

Total Other Income (Expense) Income Before Income Taxes

605,280 Office Equipment -52,868 Tax Depreciation Expense Accumulated Depreciation-Tax

Book Tax Difference

Amortization of Organization Costs Key-Man Life Insurance Premiums Bad Debts Provision Projected Actual Write-offs

BAD GANGSDUH RAPPAZ PRO FORMA AMORTIZATION OF START UP COSTS (NOTE 8)

BAD GANGSDUH RAPPAZ PRO FORMA BALANCE SHEET 2004

2005

2006 Expenditures

Current Assets: Cash and Cash Equivalents Trade Receivables Allowance for doubtful accounts

$1,118,051 1,243,000 -248,600

$2,088,405 1,274,075 -342,242

$1,206,540 Book Amortization Expense-S/L 20 1,312,297 Accumulated Book Amortization -435,914 Net Book Asset

Inventories Prepaid Expenses Ohter Current Assets Total Current Assets

2,616,000 50,000 120,000 4,898,451

1,464,650 44,600 102,000 4,631,488

1,684,348 47,900 Tax Amortization Expense-S/L 5 108,120 Accumulated Tax Amortization 3,923,291 Net Tax Asset

Property, Plant and Equipment, net Intangible Assets, net Investments

1,900,667 171,950 94,000

1,972,000 162,900 92,500

1,975,000 Corporate Book/Tax Difference* 153,850 Partnership Book/Tax Difference* 95,200 Cumulative Book/Tax Differences

45,284 6,000 $7,116,352

0 118,900 $6,977,788

Deferred Income Taxes Other Assets Total Assets Current Liabilities:

0 115,600 PRO FORMA AMORTIZATION OF ORGANIZATION COSTS (NOTE 9) $6,262,941 Expenditures

10

DATASERVE INDUSTRY BACKGROUND Computer software can be classified into two broad categories: system software and application software. System software includes (1) operating systems, which control the computer hardware, (2) compilers and interpreters, which translate programs into a form that can be executed by a computer, (3) communications software, which permits computers to send data across a network, and (4) database management systems, which are used to create, retrieve, and modify data stored in computers. Application software automates the performance of specific business functions such as payroll processing, general ledger accounting, and inventory control.

The database concept originated in the mid-1960s. A number of different models of database have been proposed and implemented over the years, distinguished from each other primarily by the forms of data storage structure which they employ. Chief amongst these are the hierarchical, network, relational, and object-oriented models. The object-oriented model is the most recent of these, developed to handle complex information structures (often found in real life), but the relational model has wider application across an extensive range of information needs. Relational database systems are undoubtedly the most frequently used (in terms of numbers of applications) at the present time and seem set to remain so for the foreseeable future.

RELATIONAL DATABASES The operation of a relational database is founded on the simple principle that data items are perceived by the user as being stored in one or more tabular structures, that is, tables arranged into rows and columns. Each table contains data items relevant to a set of "entities" (e.g. objects, people, happenings, etc.) of a specific kind. Each row of a table contains one or more data items relevant to a single entity from that set. Each column contains data items of the same kind. The tables of a relational database are "flat", that is, the intersection of a table row and a table column is a single data value (not another table).

A relational database is one in which there are separate tables for distinct data groups (e.g., building data vs. location data) with specific data elements (fields) for each respective group. The relational facilities of the data engine provide the linking of key fields to tie the data structure together.

For example, in a personnel database there would be a base table with basic data relating to an employee with a unique key linking field such as Employee Number. Utilizing the key field, a user could create composite records including the employee base data and data dealing with employment, compensation, performance, and so forth.

Relational data structures are efficient since data is not replicated and data entered once can be used many times. For example, several contact management packages are designed specifically for tasks such as tracking interactions with people -- correspondence, contractors, advisers and so on.

Sometimes called "sales support tools,'' these are database programs pre-built to keep address and phone number information; log dates, times, and subject of interaction; automatically remind you when you should call your contact again and so on. Although these packages are designed with sales departments in mind, they can work well for agencies trying to please their citizen/customers.

If one didn't keep the tables separate, one would have redundant address and contact information in some fields. It would also be harder to update the database when a contractor moved or the contact

11

changed. Keeping separate, linked tables reduces the size of the database and minimizes the work after setup.

DataServe

Jimmy and Roman, two computer engineers, are thinking about starting a database and network service company, DataServe. Jimmy is a database specialist and an expert in customizing relational database to fit individual client’s need. Roman, however, is an expert in implementing Local Area Network (LAN) or Wide Area Network (WAN). Together, they will make the database system efficient to access yet secured from uninvited visitors.

Jimmy graduated from Berkeley in 1985; his field of emphasis was database management. While in college, he found his interest in SQL (pronounced “sequel”), an English-like command language.

He was impressed with its simplicity and its power to define, retrieve, manipulate and control data stored in a relational database. He started to work for the leading database company, Oracle, right after his graduation. He knew that Oracle was the company that introduces the first commercially available relational database system using SQL. With his knowledge and interest in SQL, he knew he would enjoy his time at Oracle. The announcements in the years by standard setting agencies after his joining Oracle confirmed the potential of SQL as well as his future; In October 1986, the American National Standards Institute (ANSI) approved a standard definition for the SQL command language, which was also adopted by the International Standards Organization (ISO). The SQL standard was updated with additional capabilities in 1989.

In 1990, after years of experience with Oracle, he decided to start his own business. Inspired by the idea of implementing to relational database to improve smaller businesses, he starts customizing relational database to fit the need of individual business.

For the past few years, he has built a goodwill in the industry for excellent service.

With the package he designed, his clients are able to have multiple users utilizing the information on the database and accessing the applications concurrently while protecting the data against user and program errors and against computer and network failures. Database management systems are used to support the data access and data management requirements of transaction processing and decisionsupport systems.

With a relational database management system, the users need not know how or where their data is stored in the computer. With simple queries, also designed by Jimmy, users simply specify what data they desire, not how to retrieve it. Relational systems navigate automatically to the data, making database information readily accessible by users of all experience levels. Regardless of how the data is actually stored in the computer memory, the results of database queries are presented to users in familiar, two-dimensional tables of rows and columns of data. Relational DBMSs therefore have been widely used for management information and decision-support systems which require flexible access to large quantities of data.

Very often, Jimmy designs for his clients relational databases to store large amounts of historical or reference data, which is typically used to support the decision-making and information needs of an enterprise. Many businesses often need large amounts of information for daily operation as well as critical decision making, relational databases are facilitate the data seeking and enhance the decisionmaking process. Reliability of it is therefore very critical to a company. The databases Jimmy has built are reliable and affordable and are highly claimed by his clients.

12

However, due to limited capital and human resources, Jimmy often had to refer good business to his competitors. He is well aware of the need to expand company capacity as well as product line. He is aware of the need to expand the company. He needs capital and human resources.

Bringing in Roman is a great idea, he thought. Network and server technologies are usually an integrated part of Jimmy’s business. Without knowledge in this field, he often had to outsource portions of the business to network companies. By combining their expertise, the company can offer a complete service from building database to implementing network system to facilitate the use of information. Combined with Roman’s expertise in computer networks, they will be able to serve their client base from the desktop to massively parallel computers and are portable to a wide variety of hardware and operating system environments.

By combining their capital, they can hire more computer engineers; it will be able to take on the million projects that are likely to be asked by companies like U.S. West. In addition, they also invest more in R&D. Keeping up with the technology in the industry is part of their strategy to capture a bigger portion of the market.

The partners visit their long time friend, Joanne, who is now a business consultant, for assistance.

They want to know the effect of incorporation versus expanding by other business form. The partners hand Joanne a copy of their pro forma financial statements and ask her to advise them on the entity form that will fit the company’s best interest.

CURRENT TRENDS IN THE INDUSTRY Recently, usage of relational DBMSs has moved toward the management of multimedia information such as video, audio, text, messaging, spatial, and multidimensional data. The Company believes that this is particularly important as application development becomes more prevalent on the Internet.

Traditionally, Web-based systems have been primarily transaction oriented in nature. Because internet applications are becoming more information-oriented, relational DBMSs have become more widely used for Web-based systems. As the information on the Internet becomes more complex and widely used (video, audio, text, messaging, spatial, and multidimensional data), it is a common belief that the demand for more sophisticated DBMSs will increase.

Object-oriented DBMSs and tools are designed to support applications with "advanced" data management requirements, such as those of certain engineering applications which historically have not been able to use DBMSs. As compared with relational DBMSs, object-oriented DBMSs and tools permit more complex data structures to be defined and accessed by applications programs. However, currently available object-oriented systems provide limited capabilities for the ad hoc data access requirements of decision support systems and have insufficient performance and reliability for most business transaction processing applications. Nevertheless, with some modifications, oriented techniques can be incorporated into existing relational DBMSs without sacrificing upward compatibility and the advantages of existing relational DBMSs. Merging object-oriented capabilities with existing relational DBMSs will further broaden the applicability of relational DBMSs while providing the reliability, performance and flexibility that have been lacking in the object oriented DBMSs now available. While the Company plans to incorporate object-oriented technologies into future versions of the Oracle relational DBMS, no assurance can be given that the Company will be able to do so successfully or in a timely fashion as compared to competitive object-oriented DBMSs. In 1999, a new mobile technology product is introduced to the market. The product permits users on disconnected computers, such as laptop personal computers, to communicate with application 13

Commented [h2]: Spell out DBMSs

servers via digital radio networks. This new technology allows mobile workers to access corporate information regardless of their location and without a physical connection.

Required Discuss the merits of using various entity types for this business. Include the effects of a 20% R&D credit. Assume half of R&D is eligible for the credit; the other half is deductible.

In your analysis, assume the following: ▪

All individuals (Jimmy, Roman, and any investors) are in the 35% tax bracket. Jimmy and Roman are from wealthy families; both have net worths of $500,000. Neither Jimmy nor Roman need a salary from the business. Apply a 10% discount factor to everyone. Each year’s net income will be paid out in the form of cash distributions.

14

DATASERVE PRO FORMA BALANCE SHEET 2002 Assets Current assets: Cash and short-term investments Account receivable Allowance for bad debt Prepaid and refundable income taxes Other Total current assets

$ $ $ $

$ 1,212,054

Intangible assets, net Property, plants, and equipment, net

$ $

Total Assets Current Liabilities: Accounts Payable Customer advances and unearned revenue Short-term Debt Total Current Liabilities Long-term Debt Deferred Tax Liability

658,951 432,123 32,541 153,521

733,161 663,000

2003

$ $ $ $

456,712 512,438 43,215 123,521

2004

$ $ $ $

2005

2006

487,527 432,153 53,215 135,421

$ $ $ $

317,532 432,153 23,512 101,521

$ $ $ $

$ 1,049,456

$ 1,001,886

$

827,694

$ 1,060,107

$ $

$ $

$ $

947,162 342,000

$ $

953,241 556,000

930,427 449,000

885,202 235,000

$ 2,608,215

$ 2,558,697

$ 2,381,313

$ 2,116,856

$ 2,180,309

$ $

315,527 532,420

$ $

482,258 423,512

$ $

380,659 495,235

$ $

383,445 243,242

$ $

88,640 579,852

$

847,947

$

905,770

$

875,894

$

626,687

$

668,492

Total Liability

$ 920,495 $ 352,122 $ 2,120,564

Total Equity

$ 600,000 $ 543,826 $ 519,981 $ 507,377 $ $ (112,349) $ (160,037) $ (185,245) $ (186,835) $ $ 487,651 $ 383,788 $ 334,736 $ 320,542 $

Total Liability and Equity

$ 2,608,216

Equity: Paid-in-Capital Retained Earnings

243,581 753,125 48,951 112,352

$ 837,016 $ 432,123 $ 2,174,909

$ 2,558,697

$ 749,362 $ 421,321 $ 2,046,577

$ 2,381,313

$ 657,325 $ 512,301 $ 1,796,313

$ 2,116,855

$ 560,687 $ 542,123 $ 1,771,302

506,582 (97,576) 409,007

$ 2,180,309

15

DATASERVE PRO FORMA STATEMENT OF OPERATIONS ( in thousands) 2002 Revenue: License Service Total Revenue

$ $ $

Operating expenses: Cost of revenues $ Research and development $ Sales and marketing $ Partners Life Insurance Premium $ Provision for Bad Debts $ Depreciation Expense $ Amortization of Start-up Costs $ Amortization of Organization Costs $ General and administrative $ Compensation - John Compensation - Roman Total operating expenses $ Operating income $ Other Income (Expenses) Interest income Interest expense $

2003

2004

2005

2006

200,000 435,213 635,213

$ $ $

210,000 492,374 702,374

$ $ $

250,000 586,421 836,421

$ $ $

270,000 583,214 853,214

$ $ $

310,000 810,432 1,120,432

72,536 281,081 150,000 5,900 32,541 110,000 3,250 5,750 100,000

$ $ $ $ $ $ $ $ $

82,062 255,080 140,000 5,900 10,674 110,000 3,250 5,750 120,000

$ $ $ $ $ $ $ $ $

97,737 261,174 180,000 5,900 42,541 110,000 3,250 5,750 130,000

$ $ $ $ $ $ $ $ $

97,202 268,119 250,000 5,900 (19,029) 110,000 3,250 5,750 100,000

$ $ $ $ $ $ $ $ $

135,072 235,291 300,000 5,900 67,980 110,000 3,250 5,750 90,000

761,057 $ (125,844) $

732,716 $ (30,342) $

836,352 70

$ $

821,192 32,022

$ $

953,243 167,189

(50,000) $

(46,025) $

(41,851) $

(37,468) $

(32,866)

Income Before income taxes

$

(175,844) $

(76,367) $

(41,781) $

(5,446) $

134,322

Provision for income taxes Net Income

$ $

(61,545) $ (114,299) $

(26,728) $ (49,639) $

(14,623) $ (27,158) $

(1,906) $ (3,540) $

47,013 87,310

16

DATASERVE PRO FORMA FIXED ASSET SCHEDULE AND DEPRECIATION SCHEDULE Computer Software Development Cost

Fixed Assets - Balance Computer Equipment Office Equipment Useful Life Computer Equipment S/L Office Equipment S/L

7 10

Accumulated Depreciation Net Book Value Tax Depreciation MACRS Office Equipment MACRS

Accumulated Depreciation - Tax Book Tax Difference

7 7

2002

2003

2004

2005

2006

$700,000

70,000

$700,000 70,000

$700,000 70,000

$700,000 70,000

$700,000 70,000

2002

2003

2004

2005

2006

$100,000 7,000

$100,000 7,000

$100,000 7,000

$100,000 7,000

$100,000 7,000

$107,000

$214,000

$321,000

$428,000

$535,000

$663,000

$556,000

$449,000

$342,000

$235,000

$770,000 x. 1429 $110,033

$770,000 x.2449 $188,573

$770,000 x.1749 $134,673

$770,000 x. 1249 $96,173

$770,000 x.0893 $68,761

$-

#REF!

#REF!

#REF!

#REF!

$(3,033)

81,573

27,673

<10,872>

<38,239>

17

DATASERVE PRO FORMA AMORTIZATION OF START UP COSTS Computer Software Development Cost 2002 Expenditures Book Amortization Expense - S/L 20 Accumulated Book Amortization Net Book Asset

$65,000

2003 N/A

2004 N/A

2005 N/A

2006 N/A

3,250

3,250

3,250

3,250

3,250

3,250

3,250

3,250

3,250

$61,750

$58,500

$55,250

$52,000

$48,750

Tax Amortization Expense S/L 5 Accumulated Tax Amortization Net Tax Asset

13,000 13,000 $52,000

13,000 26,000 $39,000

13,000 39,000 $26,000

13,000 52,000 $13,000

13,000 65,000 $-

Corporate Book/Tax Difference

$(9,750)

$(9,750)

$(9,750)

$(9,750)

Partnership Book/Tax Difference

$(9,750)

$(9,750)

$(9,750)

$(9,750)

$(9,750)

Cumulative Book/Tax Differences

$(9,750)

$(19,500)

$(29,250)

$(39,000)

$(48,750)

3,250

18

DATASERVE PRO FORMA AMORTI ZATI ON OF ORGANI ZATI ON COSTS Computer Softw are Dev elopment Cost

Expenditures Amortization Expense - S/L 10 Accumulated Book Amortization Net Book Asset

2002

2003

2004

2005

2006

$115,000

N/A

N/A

N/A

N/A

5,750

5,750

5,750

5,750

5,750

5,750

11,500

17,250

17,250

17,250

$109,250

$103,500

$97,750

$97,750

$97,750

Amortization Expense- S/L 5 Accumulated Tax Amortization Net Tax Asset

23,000 $23,000

23,000 $46,000

23,000 $69,000

23,000 $92,000

23,000 $115,000

Corporate Book/Tax Difference*

-17,250

-17,250

-17,250

-17,250

-17,250

Partnership Book/Tax Difference

-17,250

-17,250

-17,250

-17,250

-17,250

Cumulative Book/Tax Differences

(17,250)

(34,500)

(51,750)

(74,750)

(97,750)

19

DATASERVE PRO FORMA AMORTIZATION SOFTWARE DEVELOPMENT COST

2002

2003

2004

2005

2006

Expenditures DEVELOPMENT COST CAPITALIZED

$843,242

$765,240

$783,521

$804,357

$705,874

$843,242

$1,608,482

$2,392,003

$3,196,360

$3,902,234

Book Amortization Expense - S/L 3 Book Amortization Prior Year Expense Total Book Amortization Accumulated Tax Amortization Net Book Asset

281,081 281,081 281,081 $562,161

255,080 281,081 526,161 817,241 $791,241

261,174 536,161 797,334 1,614,576 $777,427

268,119 516,254 784,373 2,398,948 $797,412

235,291 529,293 764,584 3,163,532 $738,702

Tax Expense

843,242

765,240

783,521

804,357

705,874

$-

$-

$-

$-

$-

Corporate Book/Tax Difference Partnership Book/Tax Difference

$(562,161) $(562,161)

$(510,160) $(510,160)

$(522,347) $(522,347)

$(536,238) $(536,238)

$(470,583) $(470,583)

Cumulative Book/Tax Diffences

$(562,161)

$(791,241)

$(777,427)

$(797,412)

$(738,702)

Net Intangible Assets - Book

$733,161

$953,241

$930,427

$947,162

$885,202

Net Tax Asset

20

DATASERVE FLOW-THROUGH ENTITY ALLOCATION Jimmy 1998 Beginning Basis Net Income (Loss) Guaranteed Payments Ending Basis

1999

2000

2001

2002

$300,000

$243,826

$219,981

$207,377

$206,582

$(56,174.35)

$(23,844.31)

$12,603.92)

(795.09)

$44,629.78

243,826

219,981

207,377

206,582

251,212

1998

1999

2000

2001

2002

Roman

Beginning Basis Net Income (Loss) Guaranteed Payments Ending Basis

300,000

243,826

219,981

207,377

206,582

$(56,174.35)

$(23,844.31)

$12,603.92)

(795.09)

$44,629.78

243,826

219,981

207,377

206,582

251,212

21

DATASERVE Loan Payment Schedule

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Beginning of Year Principal $1,000,000 920,495 837,016 749,362 657,325 560,687 459,217 352,673 240,802 123,338

Payment $129,505 129,505 129,505 129,505 129,505 129,505 129,505 129,505 129,505 129,505

Principal $79,505 83,480 87,654 92,036 96,638 101,470 106,544 111,871 117,464 123,338

End of the Year Interest (5%) Prinicpal $50,000 $920,495 46,025 837,016 41,851 749,362 37,468 657,325 32,866 560,687 28,034 459,217 22,961 352,673 17,634 240,802 12,040 123,338 6,167 0

22

STRATEGIC BUSINESS TAX PLANNING Chapter 4 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

A majority of hi-tech firms which seek external financing first do so with a private placement of common stock, followed by a public initial public offerings (IPO) of stock.

Debt is typically never issued. How does this fit into the SAVANT framework?

2.

A startup consumer products firm has two owners who are both in low tax brackets. The corporation expects rapid earnings growth over the next five years. What should it consider when deciding on internal versus external financing? (The company is a C corporation.)

3.

As a stockbroker, you have been approached by one of your wealthier clients for advice on a proposed investment in common stock, in a private placement. The firm is a newly created biotech firm, organized as an S corp. Using the SAVANT framework, what attributes of the client and company would you need to weigh before giving advice?

4.

As manager of a telecom company, you need to make a decision as to whether to pursue development of a new type of fiber optics cable. The new product has been developed through a newly formed subsidiary. If you give the “go” signal, a decision must also be made about external versus internal financing. What factors would you want to take into account for the financing decision?

5.

Not all IPOs are bought by wealthy investors with a high tolerance for risk. Many are bought by tax-exempt organizations, such as pension funds. How does this square with the SAVANT framework?

2

PROBLEMS (Refer to corresponding CONCEPT APPLICATIONS) 1.

A firm which specializes in encryption technology for commercial Internet users is considering a capital expansion. The firm has been 60% owned by its three founding members, with the remaining stock owned by 100 wealthy investors. The firm would like to raise $10 million either by a public offering of bonds or stock. A major brokerage firm (who will do the underwriting) estimates the following:

▪

The bonds would need to pay 10% semiannually (a similar firm would pay 8%); and

▪

The stock would have to be voting, and not be subordinate to existing shares. What would you recommend to management?

▪

Would you need any additional information before making this recommendation?

2.

A firm which manufactures designer sunglasses has been in operation for five years. It is organized as an S corporation, with its two owners (each having half of the stock) the president and vice president. Its current financials look as follows ($millions):

Income Statement For the Year ended 12/31/97 2/31/04 Sales Cost of good sold Gross profit Operating expenses Interest Taxes Net Income

12.5 2.5 10.0 1.0 .5 .0 $8.5

Balance Sheet For the year ended 12/31/97 12/31/2004 Assets Cash Accounts receivable Property, plant, and equipment (net)

Liabilities & Equity $35.0 1.0 5.0 $41.0

Accounts payable

$.5

Common stock Retained earnings

.5 40.0 $41.0

3

Commented [h1]: Past or present tense?

After consistent double-digit sales growth in its first five years, the company projects 20% growth for the next five. It would like to spend $30 million on a new plant, and is contemplating the following alternatives: o

Bank borrowing, at 10%, secured by the property, payable over 10 years;

o

Internal financing;

o

Floating an initial bond issue at 8% principle due in 10 years; or

o

An initial public offering (IPO) of voting common stock.

What recommendation do you have? What other information might you need?

3.

You have gathered the following on your client: Annual earnings Federal & state tax bracket Net worth Percentage of investment in high risk/ yield assets

$500,000 45% $40,000,000 20%

She is considering investing in an IPO of a biotech company. Her stockbroker provides the following relating to the biotech company: Income Statement ($Millions)

Sales Cost Gross margin Operating expenses Interest Taxes (Tax NOL)

$120 75 45 20 10 -

Net Income

$15

The company has two patents pending, both of which have an equal probability of doubling sales, or losing $1 million (in sunk R&D costs). The private placement would sell $20,000 shares of common at $1,000 each. What do you advise the stockbroker to tell his client?

4.

A telecom company is considering developing a new fiber optics technology. It is considering forming a new subsidiary to do this. The new subsidiary’s financials would look as follows:

4

Income Statement - None Balance Sheets ($ millions) Assets: Plant & equipment

$20 $20

Equity Bonds Common Stock

$19 $1 $20

Thus the parent would provide equipment, in return for which it would receive bonds and stock.

The additional development would cost $30 million. Financing could be done in a number of ways: 1. The telecom parent could provide the cash; 2. An unsecured bank loan at 15% for five years; 3. An IPO (market value unknown); or 4. Bond issuance (at 12%).

The manager has also considered forming a joint venture (using a limited liability company (LLC)) with the sub and the sub of a competitor. Provide comments on the alternatives, from the SAVANT framework.

5.

A pension fund has the following investments ($millions): Cash/Money markets Bonds: Taxable Tax exempt Common stock: S&P 500

$20 10 1

50 $81

The pension fund manager has asked you about a possible $1m investment in an IPO of a startup biotech firm. The firm is likely to have losses its first few years, but has a possibility of quadrupling in value over five years. The manager can use part of the fund’s $5 million annual earnings or sell off (and replace) any part of the current portfolio.

5

MINICASES Minicase 1 – Oil De Parfum, Inc. You are working on the audit of one of your clients, Oil De Parfum, Inc. It manufactures a highly successful line of men’s cologne’s and women’s perfumes. The firm’s 10,000 shares of stock are 51% owned by the firm’s founder, Philip Dux. The remaining stock is equally owned by his wife Dominique and two twin daughters, age ten. The financials of the Chicago-based company are: Income Statement Oil De Parfum, Inc. For the year ended December 31, 2004 Sales Cost of goods sold Gross profit Operating expenses Profit before interest and taxes Interest Taxes Net Income Earnings per share

190,364 95,182 95,182 2,000 93,182 500 31,512 $61,000 $570

6

Oil De Parfurm, Inc. (cont’d) Balance Sheets Oil De Parfum, Inc. For the years ended December 31, 2003 and 2004 ($ thousands) Assets: Cash and marketable securities Inventory (lower of cost or market) Receivables Plant and equipment

2003

2004

$50,000 12,000 13,000 250,000 $ 325,000

$60,000 15,000 70,000 240,000 $ 385,000

$7,000 307,000 1,000 10,000

$10,000 360,000 1,000 14,000

$325,000

$385,000

Liabilities and Owner's Equity: Accounts Payable Notes payable to banks Common stock ($1000 par) Retained earnings

Notes:

Dividends of $3,300 paid during year notes payable to banks are due in six months to five years, with average interest rates of 10%

Assume it is a C corporation. What tax concern can you bring up with the firm’s current capital structure? What would you recommend as an alternative capital structure, using SAVANT framework?

7

MINICASE 2: Simworld, Inc. Simworld, Inc operates a highly successful chain of virtual reality game arcades in a large city.

Owned by a single owner, the keys to its success were two fold: location (as close as possible to major entertainment centers, e.g. a cineplex); and technology. The technology was kept fresh through the owner’s contacts with engineers in the industry.

Organized as an S corp., its current financial are: ($millions): Income statement for the year ended ended Dec. 12/31/97 31, 2004 Revenues Operating expenses Taxes Interest Net income

$10.0 5.0 0 1.0 $4.0

Balance sheet for the year ended Dec. 31, 2004 Assets Cash Receivables P,P, & E (Net)

10.0 1.0 5.0 $16.0

Liabilities and Equity Payables Stock Retained earnings

.5 .5 15.0 $16.0

The owner is considering opening 10 new arcades in a new city. Each would require an additional $1 million investment in equipment, and so forth. Each was projected to run tax (and financial) losses of $200,000 its first two years, then positive incomes of $100,000 with 20% growth thereafter.

The owner seeks consulting advice on how to finance the expansions. Assume 10-year bank financing would be 8%, 10-year bonds would have to pay 10%. Provide a number of alternatives to the owner, over a 10-year horizon, assuming a minimal rate of return of 8%.

8

COMPREHENSIVE STRATEGY CASES: WMS INDUSTRIES, INC and DATASERVE (PART 2) Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

9

WMS INDUSTRIES, INC. WMS Industries was a privately held C corporation, which manufactured state-of-the-art TV video games. Its primary rivals were SNES, SEGA, and NINTENDO. The firm’s strategic plan was to become THE dominant game company. To that end, its management decided on a $15 million expansion program. Half would be spent on R&D, and half on new plant and equipment.1 The investment was expected to pay off in 25% increase in 2005, with no charge in subsequent years' sales. The only unresolved issue was financing.

Commented [h2]: Statement is unclear

The firm’s stock was owned 20% each by John Williams, Sally Munroe, and David Sanchez, the founders. The remaining stock (nonvoting) was owned by a group of 30 investors, who invested 5 years ago (at the firm’s inception) through a private offering.

There were a number of options for financing: ▪

Internal. This might involve liquidating some assets.

▪

Bank borrowing at 12% due in five years. Its current debt (held by private investors) was 12% bonds due in five more years (callable if its debt > equity)

▪

An initial public offering (IPO). Similar firms were trading at 10 times earnings. Stock convertible into bonds was possible.

▪

Additional bonds at 10%, perhaps convertible at 9%, due in 10 years.

MACRS depreciation and R&D credits, for the first two years after expansion, would might keep the firm out of a tax-paying position, regardless of the source of financing. Tax rates were expected to go up in the next year by 2%.

What do you recommend?

1

Assume the equipment has a 10-year life, and is a 7-year MACR asset.

10

Commented [h3]: Would or Might?

Consolidated Statements of Income Years ended June 30 (in thousands) Revenues

$

Costs and Expenses: Cost of sales Research and development Selling and administrative Total costs and expenses

2004 112,875

76,086 15,310 17,883 109,279

Operating income

3,596

Interest and other income Interest expense

1,451 (1,228)

Income from Continuing Operations Before Income Taxes Provision for income taxes

3,819 (1,327)

Income from Continuing Operations

$

Discontinued operations Income(loss) from discontinued operations, net of tax of $823 Costs related to discontinuance, net of tax(credit) of ($1,400) Income(loss)-discontinued operations Net income

984 (1,964) (979) $

Earnings per Share Consolidated Balance Sheet June 30 (in thousands) Assets: Current Assets: cash and cash equivalents short-term investments receivables, net of allowances of $913 Inventories Raw materials and work in progress Finished goods deferred income taxes other current assets Total current assets Investment in marketable equity securities Property, plant and equipment, net Other assets Total Assets

2,492

1,513 0.06

2004

$

$

11,183 9,036 25,655 13,444 7,574 21,018 1,411 3,838 72,141 6,479 12,841 5,402 96,863

11

Current Liabilities: Accounts payable Accrued compensation andrelated benefits Income taxes payable Deferred income taxes Accrued payment on acquisition Accrued discontinuance costs Accrued royalties Other accrued liabilities Total current liabilities Long-term debt Deferred income taxes Other noncurrent Stockholders' equity: Preferred stock Common stock Additional paid-in capital Retained earnings

$

4,033 27,499 19,720

Treasury Stock Unrealized loss on noncurrent marketable equity securities Total Stockholders' Equity Total Liabilitites and Stockholders' Equity

7,944 2,120 1,095 3,504 2,036 6,528 23,228 21,788 2,183 1,236

(49) (2,774) 48,429 $

96,863

NOTES 1. Discontinued Operations. One was the sale of computer equipment and software related to “Commandos,” an action game, resulting in a gain. The second was sale of equipment and software for “Simski,” at a loss.

2. Cost of sales includes $8 million in straight-line depreciation. MACRS depreciation would have been $10 million.

3. R&D is expensed as incurred.

4. Bad debts are written off only as they go bad.

12

DATASERVE (PART 2) Refer to the original data in Dataserve (Chapter 3). Assume that the business is organized as a corporation. Assume it is early in 2005.

Jimmy and Roman have made the first step toward expansion: the decision to elect S corporation status. They have developed a strategic plan to become the most successful relational database company in their city. This implies expanding beyond current clients into a number of service industries. Their strategy calls for the following expansion over the next year: ▪

Hire two new engineers at $60,000 each

▪

Hire three new programmers at $35,000 each

▪

Acquire $200,000 in computer equipment

▪

About 50% of salary will be for R&D

These investments are expected to yield no new revenues in the first year, as software is being developed. After that, they expect revenues to grow by 50% per year, for at least five years. Related costs are expected to grow by 20%. The firm’s internal cost of capital is 10%.

The remaining question is: how to finance the expansion? A number of alternatives appear feasible: ▪

▪

▪

Going through major brokerage firms and underwriters, they could; o

Do an IPO. The issue could be priced at five times current earnings

o

Issue bonds at 10%, payable semi-annually, due in 20 years.

o

Both would entail the usual transaction costs

Go through brokers, and either get; o

Wealthy investors in a private placement of common stock. Quarterly dividends would be expected, and they would have voting power; or

o

Venture capitalists. They would loan money at 12%; repayment of principal would be after 5 years in the form of 50% of accumulated net profits. They would also want a seat on the Board of Directors.

Obtain bank loans at 12%, collateralized by equipment, interest and principal paid monthly over five years.

In order to obtain any financing, the firm must prepare projected financials for the next four years. Assume the state income tax rate on regular corporations is 9%, on individuals 10%.

What method of financing should be used?

13

STRATEGIC BUSINESS TAX PLANNING Chapter 5 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

It is well known that Coke and Pepsi are in a constant struggle for market dominance.

Suppose one year Pepsi, through effective tax management, brings its effective tax rate down to 10%. Coke is at 40%. Should the difference in tax rates affect amount and/or timing of new product research and development? Discuss.

2.

As marketing manager for a publishing company, you are debating how to best promote a new book. Your pre-tax promotional budget is $15 million. A push (sales force intensive) strategy would generate $20 million in sales, and would consist of 50% travel and entertainment, and 50% salaries for newly hired sales force. A pull (advertising intensive) strategy (for the same cost) would have a more uncertain payoff; you estimate a 50% probability of $30 million in sales, and a 50% probability of $10 million in sales.

What is your strategy?

3.

Your company is in a three-way race to develop a super-whitening laundry detergent.

The product’s success hinges on the development of an enzyme. You estimate that additional R&D will cost $1 million (for either you or your competitors) with a resulting patent providing a “winner takes all” outcome to the successfully innovating firm. Your firm is in an NOL carryforward status, which it expects to come out of next year. One competitor is in an identical tax situation, while a third is in a taxpaying status. How should the tax status of all parties affect the timing of your R&D?

4.

You are Chief Executive Officer for a cellular phone company which services southeastern states. A market analysis indicates there may be some demand in some nearby central states. To stimulate demand, you are considering a trade show in three major cities (each in a different state), possibly followed up by opening sales offices.

What tax factors should you consider?

5.

For the following products, discuss where they appear to be in terms of promoting tax advantage: 1. Retirement savings vehicles (IRA, pension, deferred annuity) 2. Personal computers and related software 3. Airline travel 4. Restaurants 5. College courses

2

PROBLEMS For each of the following problems, refer to the corresponding Concept Application.

1.

Suppose, to maintain market share, both firms need to spend about $10 million each, over any five-year period. Assume a cost of capital of 10%. What strategy would you recommend if you were a consultant to Pespi?

2.

Assume you are consultant to the book company. The firm’s cost of capital is 10%, and it is in the 34% tax bracket. Make a recommendation based on a two-year analysis. How would your recommendation change if the marketing manager’s bonus were 1% of aftertax profits?

3.

Suppose the R&D winner could expect an additional pre-tax profit of $10 million. If all firms spent the same amount (or within 15% of each other), they would have equal chances of winning. However, a competitor outspending his other competitors could significantly increase his profitability of winning. As consultant to the company, what would you advise?

4.

Suppose the three new states have corporate income tax rates of 10%, 3%, and 0%, respectively. Assume the firm can spend up to $500,000 in new promotion. Each dollar of promotion has a 50% chance of generating $4 of pre-tax income, and a 50% chance of generating 50% of income. You can allocate at most 50% to just one state.

5.

Because any losses would cause the firm’s debt covenants to be violated, $100,000 of legal fees would be required to renegotiate the debt. As a consultant, what would you recommend?

6.

Assume that your firm sells computers to both commercial and residential customers.

One of your large business customers wants to buy additional units from you at a 20% discount. The major supplier of your components has a net operating loss (NOL) carryforward which is about to expire and is currently selling components at 50% above its cost (components are 90% of your manufacturing cost). What strategy can you recommend?

3

Commented [h1]: Do you mean Pepsi?

MINICASE As Chief Executive Officer of a consumer product firm, you have discovered that you have $2 million in unanticipated free cash flow this year. Your managers have come to an impasse on whether to use it on development of one of two possible products: a new design toothbrush, or a razor blade, which needs replacement only after 100 shaves. The former is not highly innovative, costs little to develop, and will not be a huge market success. The razor requires development of a special alloy, which has a 50% probability of success. However, such a product would have “home run” market potential, and requires only inexpensive promotion.

Projections from your marketing group are:

R&D Costs Promotion costs

Toothbrush

Razor Blade

500,000 1,500,000

1,500,000 500,000

Estimated profits (pre-tax before R&D and promotion) 4,000,000

20,000,000 (if sucessful development)

4

The company’s financials before either operation are: Income Statement For the year ended 12/31/04 ($000s) Sales Cost of goods sold Gross margin Selling, general, and administrative Nibit Interest expense Net income before taxes (NIBT) Taxes (federal = 34% state & local = 10%) Net Income Earnings per share

$20,000 12,000 8,000 6,000 2,000 1,000 1,000 440 560 $5.60

Balance sheet For the year ended 12/31/04 Assets Cash Receivables Plant and equipment (net)

Liabilities and Equity 10,000 5,000

Accounts payable Bonds payable

85,000 100,000

Common stock Retained earnings

You also learned the following facts: ▪

The bonds had an agreement that if net income fell below zero, the interest rate would double.

▪

Management’s’ salary was largely based on performance bonuses, which were 10% of net income What is your recommendation? Support your answer with calculations.

5

COMPREHENSIVE STRATEGY CASES: TURNER SISTERS and

DATASERVE (PART 3) Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT4 framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

6

Commented [h2]: Is there a footnote?

TURNER SISTERS Commented [h3]: Please verify the heading levels are correct in this section.

EXECUTIVE SUMMARY Tuner Sisters (Turner) is a publicly traded corporation which develops software for video games.

As discussed below, Turner must employ sound strategy at every development stage in order to produce a “hit” in the target market(s). The key strategic points to consider for each Turner project are: ▪

Turner must look for the “win-win” situation to enable it to maximize the value of a developed title and to generate long-term profits. This includes working closely with various parties to design, produce and market a high-quality game.

▪

Turner must be knowledgeable about the various development groups in order to determine their limitations (e.g., capacity and talent).

▪

Turner must develop the game in as many formats as possible to maximize revenue.1 The primary format in the near term2, however, must be the CD-ROM which will allow Turner to present properties in “cutting-edge” products.

▪

Turner must maintain approval rights to ensure that games produced by another party are high quality so that they meet Turner’s high standards.

▪

Turner must work closely with retailers to determine trends, needs, problems, and so forth.

▪

Turner must work closely with trade magazine publishers to ensure that Turner products are highly visible to the target market(s).

DISCUSSION Background

The video game market expects to see sales grow by 34% to 5.9 billion in 2003. The growth will be sustained by the continued development of faster and more powerful hardware. The primary hardware producers are Nintendo, Sega, NEC, and Sony; Atari has maintained a presence, but it is less significant than the others are. In addition to the technological progress in enhancing the capacity of the hardware, most of the major players are also developing the software capabilities (i.e., cartridges and CD-ROM) of the hardware. Thus video game producers must be cognizant of the advancements in the home computer technology to determine the potential market for games.

Hardware Profile

The following is a summary of the expected growth rates of the established domestic hardware bases between the first quarter of the 2003 and the first quarter of 2004: NES SNES

13.3% 300%

1

A linear programming model might be useful to consider the myriad of constraints to meet this objective.

2 Generally this is a five-year window.

7

GameBoy Genesis Game Gear Turbo Graphics Home Computers

50.6% 233% 38.5% NIL Information not available

Considering the projected growth rates above, properties that Turner develops must consider the SNES and Genesis hardware. These should be supported in both cartridge and CD-ROM formats. The latter would likely be usable in home computers as well.

CDROM Review

CD-ROM is considered to be the primary format that will satisfy the ever-increasing demands of the target markets (identified below). As a result, producers, such as Turner, must use the capabilities of the CD-ROM to meet those demands. Multiple benefits inure to both the producers and players with the CD-ROM format in that: ▪

CD’s have superior memory capacity

▪

CD’s allow still photos to de-digitalized so as to “bring them to life” to the point that they are movie quality

▪

CD’s provide longer game play and allow the player to be more involved

▪

CD’s are less expensive to produce than cartridges

▪

CD’s are easily ported to different systems thus allowing the development cost to be allocated to more SKUs

▪

CD’s will be less expensive to the consumer

All of the major players identified above plan to introduce CD-ROM hardware that will attach to their current systems in the market. Producers of video games, like Turner, have a significant opportunity to meet the demand for CD-ROM formatted games that will accrue with the introduction of the new hardware.

Consumer Profiles

Preteens and teen boys continue to be the primary target market. The members of this segment tend to favor the faster, more powerful systems. This market segment demands sophisticated games with advanced graphics, multiple levels, and fast action. These requirements are best supported by the CD-ROM format. Games must be challenging, fun, and entertaining. Turner has a wealth of titles that could be developed to meet the demands of this important market segment.

To date, the market segment of preteen and teen girls has not been significant; however, there is potential to develop it. Turner must proactively address the demands of this potentially lucrative market segment by identifying and developing titles that will attract its members.

Titles developed for both the preteen boys and girls segments have been very successful.

These include Tiny Toon Adventures which has been very profitable for all parties involved.

8

A significant segment of male and, surprisingly, female audiences are attracted to the handheld systems which require hand/eye coordination. Turner should identify and develop properties that would “fit” the medium as well as fit the action requirements of the target market.

Finally, as producers develop more sophisticated interactive games, an older audience, both male and female, can be expected to buy video games. These segments are extremely important to Warner since these people have the greatest purchasing power. Turner should concentrate its production efforts in this area to gain a pioneer position in the marketplace.

Game Evaluation and Development

In order for Turner to take advantage of the increasing demands of the various market segments, its producers must always develop games that include: ▪

Games must be fun and entertaining so as to present a personal challenge to the player

▪

Concepts must be fresh

▪

Graphics must be state-of-the art and highly interactive

▪

Sound effects must be complementary to the action of the game Turner must also consider the following parameters in the development of video games:

▪

They take approximately 12 months to develop

▪

There are intrinsic and extrinsic limitations—configuration, design, and programmer capability

▪

Development costs start at $250,000

Finally, Turner must remember that a strong title will not necessarily make the game successful. Game play must meet the demands of the target segment(s), which include action adventure, role-playing, and coordination games.

Advertising Support

All titles that Turner either produces in-house or licenses must be supported by a print ad campaign in various trade magazines. It is vital to a game’s success to be reviewed by the magazines’ publishers and to garner the cover positions. Thus it is important that Turner cultivate relationships with these magazine publishers. Another advertising tool is to display the games at consumer electronic shows throughout the United States. Various marketing techniques must be employed (e.g., fun word-of-mouth advertising so vital to the success of any game. This is true whether Turner produces the title in-house or licenses it to another party. Finally, TV commercial support is beneficial but its marketing division would have to address this consideration.

THE DECISION Turner needed to decide on in-house versus licensing for its year 2000 plan. Attached are projections for an average title. Five titles would be produced in 2000. Its major competitor, Fractal, Inc, was also publicly traded; Turner and Fractal each had 30% market share and sold to the same hardware companies.

9

Commented [h4]: Who’s Warner?

TURNER SISTERS (TS) ASSUMPTIONS AND COMMENTS

(1)

The CD maturation rate is assumed to be 100% in the near term. However, this does not take into consideration potential competition from home computers or the availability of video games through cable networks.

(2)

The attached computations are made in nominal dollars. Since the inflation rate has been relatively low and stable over the last several years, assume that the fed will continue to pursue a stable rate. Thus the effects of inflation have been ignored.

(3)

The time value of money should be considered in the attached analysis. Presumably, the discount rate, and its inherent risk factor, would be the same under both scenarios.

Assume a discount rate of 10% in calculating the net present value of the alternatives.

(4)

Tax effects should not be considered in this analysis. Assume a 39.9% federal/state tax rate. Turner has a net operating loss carryforward of $1 million from 2004. In-house (but not licensed) R&D is eligible for the R&D credit. Assume no depreciation for tax and book (in overhead). Turner can contract with either Fantasyworks, Inc or Siborg, Inc to do the licensed software development. The latter has an NOL expected to last 10 years. Assume 20% of first year R&D expenditures eligible for R&D credit.

(5)

The exercise looks only at domestic sales. If international sales were considered, there are tax efficiencies in structuring the deal differently so as to shelter royalty revenue from taxation. Potentially, this could change the recommendation on page 2 (as for the production of TS titles, presume that it would be difficult to effectively produce them offshore so as to be unable to shelter the net profits as efficiently).

(6)

50% of Turner’s management compensation was in the form of a bonus on pre-tax accounting earnings. The bonus is 10% of the increase in per-title profits over the previous year. 2004’s per title profit was $400,000.

10

SUMMARY OF ESTIMATED REVENUES In-House Production of TS Titles

Cartridge SNES Cartridge Sega CD SNES CD Sega Estimated Profit per Title per Year

2005

2006

2007

93,130 294,870 0 0

283,000 625,333 0 0

490,981 1,005,077 -106,476 250,667

$388,000

$1,159,000

$2,570,400

2008

385,263 847,981 539,879 2,836,797

2009

5-year Total

262,720 599,280 1,531,400 4,533,000 $6,926,400

$15,653,720

$2,974,000

$9,328,880

$4,609,920 LICENSING AGREEMENT Greater of Estimated Royalty Revenue of Term Guarantee

$943,600

$1,426,000

$1,696,000 $2,289,280

11

Analysis to Produce TS Titles In-House or to License TS Titles to Independent

2005

2006

2007

2008

6,000,000 7,000,000

7,000,000 8,500,000

7,500,000 10,000,000

8,000,000 11,000,000

9,000,000 12,000,000

0 0

0 800,000

500,000 1,500,000

1,500,000 3,000,000

3,000,000 4,500,000

Cartridge Maturation Rate CD Maturation Rate (Assumption 1)

100% 100%

100% 100%

80% 100%

60% 100%

40% 100%

Penetration: CartridgeSNES Sega

1.50% 2.00%

1.50% 2.00%

1.50% 2.00%

1.50% 2.00%

1.50% 2.00%

CD SNES Sega

5.00% 5.00%

5.00% 5.00%

5.00% 5.00%

5.00% 5.00%

5.00% 5.00%

90,000 140,000

105,000 170,000

90,000 160,000

72,000 132,000

54,000 96,000

0 0

0 40,000

25,000 75,000

75,000 150,000

150,000 225,000

Domestically Installed Unit Bases: CartridgeSNES Sega CD SNES Sega

2009

Installed Unit Base Expected to Purchase a Given TS Title CartridgeSNES Sega CD SNES Sega

12

SCENARIO 1 Produce TS Title In-House: 2005

2006

2007

2008

$5,400,000 2,160,000

$6,300,000 2,520,000

$5,400,000 2,160,000

$4,320,000 1,728,000

$3,240,000 1,296,000

Variable Costs Manufacturing Distribution Subtotal Contribution Margin

1,980,000 486,000 2,466,000 774,000

2,310,000 567,000 2,877,000 903,000

1,980,000 388,800 2,368,800 871,200

1,584,000 311,040 1,895,040 696,960

1,188,000 233,280 1,421,280 522,720

Fixed Costs Development Packaging Marketing Overhead Subtotal

250,000 20,000 332,609 78,261 680,870

250,000 20,000 283,333 66,667 620,000

150,000 20,000 170,803 39,416 380,219

150,000 20,000 115,129 26,568 311,697

150,000 20,000 73,125 16,875 260,000

Estimated Profit per Title per Year

$93,130

$283,000

$490,981

$385,263

$262,720

$8,400,000 3,360,000

$10,200,000 4,080,000

$9,600,000 3,840,000

$7,920,000 3,168,000

$5,760,000 2,304,000

Variable Costs Manufacturing Distribution Subtotal Contribution Margin

3,080,000 756,000 3,836,000 1,204,000

3,740,000 918,000 4,658,000 1,462,000

3,520,000 691,200 4,211,200 1,548,800

2,904,000 570,240 3,474,240 1,277,760

2,112,000 414,720 2,526,720 929,280

Fixed Costs Development Packaging Marketing Overhead Subtotal

250,000 20,000 517,391 121,739 909,130

250,000 20,000 458,730 107,937 836,667

150,000 20,000 303,650 70,073 543,723

150,000 20,000 211,070 48,708 429,779

150,000 20,000 130,000 30,000 330,000

$294,870

$625,333

$1,005,077

$847,981

$599,280

SNES Cartridge Revenue Gross Trade Discount

2009

Wholesale Revenue

Sega Cartridge Revenue Gross Trade Discount Wholesale Revenue

Estimated Profit per Title per Year

13

SCENARIO 1 Produce TS Title In-House (cont'd): 2005 SNES CDRevenue Gross Trade Discount

2006

2007

2008

2009

$0 0

$0 0

$1,500,000 870,000

$4,500,000 2,610,000

$9,000,000 5,220,000

Variable Costs Manufacturing Distribution Subtotal Contribution Margin

0 0 0 0

0 0 0 0

200,000 75,600 275,600 354,400

600,000 226,800 826,800 1,063,200

1,200,000 453,600 1,653,600 2,126,400

Fixed Costs Development Packaging Marketing Overhead Subtotal

0 0 0 0 0

0 0 0 0 0

400,000 20,000 7,664 33,212 460,876

400,000 20,000 19,373 83,948 523,321

400,000 20,000 32,813 142,188 595,000

Estimated Profit per Title per Year

$0

$0

-$106,476

$539,879

$1,531,400

Sega CD Revenue Gross Trade Discount

$0 0

$2,400,000 960,000

$4,500,000 1,800,000

$9,000,000 3,600,000

$13,500,000 5,400,000

Variable Costs Manufacturing Distribution Subtotal Contribution Margin

0 0 0 0

320,000 216,000 536,000 904,000

600,000 324,000 924,000 1,776,000

1,200,000 648,000 1,848,000 3,552,000

1,800,000 972,000 2,772,000 5,328,000

Fixed Costs Development Packaging Marketing Overhead Subtotal

0 0 0 0 0

500,000 20,000 107,937 25,397 653,333

400,000 20,000 142,336 32,847 595,182

400,000 20,000 239,852 55,351 715,203

400,000 20,000 304,688 70,313 795,000

$0

$250,667

$1,180,818

$2,836,797

$4,533,000

Wholesale Revenue

Wholesale Revenue

Estimated Profit per Title per Year

14

SCENARIO 2 LICENSING AGREEMENT

SNES Cartridge Wholesale Revenue (from Scenario 1) Sega Cartridge Wholesale Revenue (from Scenario 1) Subtotal Royalty Rate Cartridge Royalty Revenue SNES CD Wholesale Revenue (from Scenario 1) Sega CD Wholesale Revenue (from Scenario 1) Subtotal Royalty Rate CD Royalty Revenue

2005

2006

2007

2008

$3,240,000

$3,780,000

$3,240,000

$2,592,000

$1,944,000

5,040,000

6,120,000

5,760,000

4,752,000

3,456,000

8,280,000

9,900,000

9,000,000

7,344,000

5,400,000

2009

12%

12%

12%

12%

12%

993,600

1,188,000

1,080,000

881,280

648,000

0

0

630,000

1,890,000

3,780,000

0 0 20%

1,440,000 1,440,000 20%

2,700,000 3,330,000 20%

5,400,000 7,290,000 20%

8,100,000 11,880,000 20%

0

288,000

666,000

1,458,000

2,376,000

993,600 50,000

1,476,000 50,000

1,746,000 50,000

2,339,280 50,000

3,024,000 50,000

Net Royalty Revenue

$943,000

$1,426,000

$1,696,000

$2,289,280

$2,974,000

Term Guarantee

$500,000

$500,000

$500,000

$500,000

$500,000

Total Royalty Revenue per Annum Licensing Overhead per Annum

Note: Since there is no direct investment by Turner, licensing agreements are effectively "off balance sheet."

15

DATASERVE (PART 3) Refer to the original DataServe case in Chapter 3. Assume the firm is a C corporation.

After just one year from the formation of a corporation combining the two sole proprietorships, Dataserve’s engineers and programmers believe they can develop an inexpensive prototype of SAP. Like SAP, the system can link, real-time, all databases and programs of every computer in a large company.

Jimmy and Roman are now attempting to allocate funds to various projects, including the new program. The firm’s annual free cash flow of $300,000 is the limit to such spending (the two owners do not want to seek external financing yet). The decision will come down to allocating between R&D and promotion.

They estimate that the new program will take an additional $240,000 of investment (over two years) before it is marketable. They estimate that the new program will bring in anywhere from 20 to 50% revenue growth over a five-year period.

Promotion of current products and services in their best estimates follows the following form: St- = St-1 + 1.2Pt, where St = current year sales, St-1 = last year’s sales, and Pt is the current year’s promotion expenditures

How should the firm allocate between promotion and R&D over the next two years?

Assume that 20% of any additional R&D spending is eligible for the R&D credit.

16

STRATEGIC BUSINESS TAX PLANNING Chapter 6 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

As Chief Executive Officer for a computer software consulting company, you have been looking at two employee options which could increase profitability. Specifically, you would replace some of your full time programmers with either: o

College students, or

o

Leased employees, from an employment firm. In either case, no annual contracts would be given to the replacement workers, who would work 20 hours per week, on average. Discuss from a SAVANT perspective.

2.

A privately owned biotech firm is considering offering its management stock options. It has net operating loss carryforwards, and is thinking of an initial public offerings next year. What is your advice?

3.

As marketing manager of an athletic shoe manufacturer, you have been offered a new contract of either straight salary or salary plus a bonus. The bonus is based on overall company economic value add (EVA). What might you negotiate for, in lieu of these two possibilities?

4.

As Chief Financial Officer of a telecommunications company, you have overseen a major technology upgrading plan which will require substantial outlays over the next five years.

To conserve cash, you have offered management two possible deferred compensation plans: 1. 50% of each year’s salary would be put in a bonus plan, which would be paid in five years, plus a 10% return, or one-tenth of a percent of firm EVA, whichever is higher, or 2. Stock options, currently worth 50% of each year’s salary, which could be exercised in five years.

Discuss both plans.

5.

How would you expect executive compensation to differ between: o

Startup versus mature companies?

o

Private versus publicly traded firms?

o

Firms with volatile versus stable earnings?

o

Companies in high versus low growth industries?

2

PROBLEMS (Refer to corresponding Concept Application) 1.

Suppose you were considering replacing 50 full-time programmers, each receiving the following annually: o

$60,000 salary

o

$5,000 pension fund contributions

o

$1,000 each in medical, life insurance, and dental plan payments

o

FICA and unemployment taxes

Each programmer would be replaced by 3 part-timers, each working 20 hours per week at $10 per hour, with no benefits. Assuming the firm is in the 45% (federal plus state) tax bracket, and privately held, provide a consultant’s recommendation.

2.

The options would allow the purchase of one share at $20 (the current estimated value of a share). Each of the firm’s 10 managers would be offered 1,000 shares. Currently, the 10 owners have 10,000 shares each. The initial public offerings would attempt to sell 100,000 shares at $21. The net operating loss carryforward is $400,000, which could be used to partly offset next year’s projected taxable income of $600,000. What is your consultant’s recommendation?

3.

The two compensation options are: 1. Salary of $1 million, or 2. -$300,000 salary, plus 5% of EVA (current EVA is $14 million).

The shortened version of the firm’s income statement is as follows ($ millions): Sales Cost of goods sold Gross margin Operating expenses Interest Taxes Net Income

1,000 550 450 300 50 50 $50

The firm’s weighted average cost of capital is 10%. 20% of the operating expenses are selling/marketing related. What is your consultant’s recommendation?

4.

Current salaries are $10 million. The firm’s current EVA is $500 million, on an 8% weighted average cost of capital. The stock is currently trading at 100 3/8, with a 5% growth over the last five years.

5.

Examine actual management compensation from firm proxy statements. Do they agree with your predictions? Why or why not?

3

MINICASE A firm is trying to hire a top executive away from a competitor. The executive’s current compensation package is: Salary Bonus (1% of pretax earnings) Stock options (current value)

800,000 400,000 2,000,000

Because of the executive’s expertise at cost cutting, hiring the executive would likely reduce G&A costs by 10% per year. To lure the executive away, you would have to offer a 20% increase over his current compensation. The condensed version of the company’s income is as follows ($millions): Sales C ost of sales G ross margin Selling G &A Interest Taxes N et Income

370 200 170 20 50 20 0* 80

*N O L carryforward of $80 million will keep firm out of tax-paying position for two years.

There are currently 10 million shares of common stock outstanding, with a market value of $500 million.

After analyzing a straight 20% proportional increase in the executive’s salary, suggest alternative (but equivalent) packages. What is your recommendation to management?

4

Commented [h1]: Please spell out G&A

COMPREHENSIVE STRATEGY CASES: JEANS2 and DATASERVE (PART 4) Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expect you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

5

JEANS², INC. Dave Brooks looked around the boardroom table, and his gaze was met with faces which reflected excitement and enthusiasm. And why not: his Los Angeles based Jeans², Inc. (a C Corporation) had just had another record year. Only in its third year of operation, sales had grown a steady 20% each year. Although, as chairman and founder, Brooks was the heart and soul of the retail clothing chain, the real force behind the explosive growth was Kathleen Kim. Top on the agenda for the board meeting was to determine how to compensate her using incentive stock options (ISO). The Board needed to decide whether, for tax purposes, to give her ISOs versus non statutory stock options. The plan was to give (nil option price) Kathleen an option to buy up to 10,000 shares of Jeans² stock, at an exercise price of $100 per share. The stock was currently trading at $150 per share. If the company had another solid year, the stock price would likely be up to $175. Under the proposal, Kathleen would be able to exercise her options at any time.

In considering the statutory versus nonstatutory ISOs, Brooks considered the following facts: ▪

Although currently enormously profitable, Jeans² had a huge tax NOL in its first year of operation. The NOL carried forward would likely keep the company out of a tax paying position in 2004, but not fully in 2005 or in 2006.

▪

Brooks is concerned about the financial accounting impact of the ISOs. The company's controller told him that, under current financial accounting rules1, the following would occur: o

The company would have to record compensation expense at the time of issuance. The expense would equal the difference between the option price (to Kim) and the stock's market value.

o

The options, for purposes of computing earnings per share (EPS), would be treated as if they had been exercised.

▪

To finance the company's expansion, Jeans² planned to float a public offering of an additional 500,000 shares. Currently, there are 100,000 shares issued and outstanding.

▪

In lieu of the ISOs, Brooks is considering paying Kim a $500,000 cash bonus. Regardless of whether the ISOs or cash bonus is given, Kim would be paid her normal $200,000 salary.

▪

Another alternative is to issue nonqualified stock options. Under current financial accounting rules, a footnote disclosure would show the potential compensation expense, and dilution of EPS.

1

ARB 43 (Chapter 13B), APB 25, FASB Interpretations 28, 31 and 38, and FASB Technical Bulletin 82-2.

6

JEANS INC. Statement of Income (Adjusted for Schedule M Items) Scenario 1 - No Bonus nor ISO PROJECTED 12/31/05

12/31/04

PROJECTED 12/31/06

Net Sales

82,024,037

98,997,339

121,968,814

Cost of Sales

54,202,387

68,500,402

84,389,391

Gross Profit

27,821,650

30,496,937

37,579,423

Selling, General and Administrative Expenses: (includes Kim's salary but no bonus nor ISO) 17,639,357

21,264,214

26,242,761

Operating Income

10,182,293

9,232,723

11,336,662

Other Income (Expense): Interest Income Interest Expense Other

296,329 -868,736 -136,578

147,058 -736,248 -139,627

394,817 -181,577 -235,275

Income Before NOL

9,473,308

8,503,906

11,314,627

-11,254,366

-1,781,058

0

Net Operating Loss (NOL) Carryforward Income Taxes

0

2,285,768

3,960,119

($1,781,058)

$4,437,080

$7,354,508

$95

$85

$75

100,000

100,000

150,000

$150

$175

$200,000

$220,000

$242,000

Po rtfo lio Inc o m e

1,365

1,800

2,200

C a p ita l G a ins fro m no nsto c k tra nsa c tio ns

3,498

3,500

3,800

AG I G ro ss Ite m ize d De d uc tio ns: M o rtg a g e Int., Pro p e rty Ta x, C o ntrib utio ns Pha se O ut Ne t Ite m ize d De d uc tio ns

204,863

225,300

248,000

22,976 -2,892 20,084

24,000 -3,506 20,495

26,000 -4,187 21,814

Ta xa b le Inc o m e

184,779

204,806

226,187

Re g ula r Ta x Lia b ility (@35%)

64,673

71,605

79,130

Net Income Net Income (pre NOL) per share (A) Weighted Average number of shares outstanding Curre nt M a rke t Pric e

Unkno w n

(A) Assume tha t this is e quiva le nt to book EPS

Ka thle e n Kim U.S. Individua l Inc ome Ta x Re turn Filing Sta tus: Single Sa la ry

Exe m p tio n

7

DATASERVE (PART 4) Refer back to the original Dataserve case (Chapter 3), and assume: (1) The firm is now incorporated; and (2) The firm received $1 million from an IPO during the first year.

Jimmy and Roman have begun to realize that, while their technical expertise is exceptional, their managerial abilities left something to be desired. With the planned expansion, and their continued involvement in product development, they felt it was time for professional management.

The leading candidate was Dana Anderson, currently the Chief Executive Officer of Cybersoft, a leading software company specializing in medical applications. She had engineered a 1,000% return on investment at the firm in just three years, and was rumored to be in search of a new challenge.

Jimmy and Roman put together the following package: Cash Compensation

$300,000

Bonus

10% of net income

Stock options

10% of outstanding stock, for $101 /share (stock currently trading at $100)

The firm is concerned about costs, motivating factors, and financial statement impact. With regard to the latter, some of the firm’s bank loans had a clause that if equity declined by more than 10% in two successive years, the loans could be called.

This package could, of course, be negotiated. It was known that Anderson was a risk-seeker, so more emphasis on options was certainly a possibility.

Recommend a package which would work for both the firm and Anderson.

8

STRATEGIC BUSINESS TAX PLANNING Chapter 7 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

You are Chief Financial Officer for a company that sells contact lenses by mail order to a notional market. Despite the national presence, the firm’s facilities are all located in one state. Your tax department has suggested that you locate two additional offices in states with no or very low corporate taxes (Nevada and Texas, respectively). Discuss the tax and non-tax merits of this suggestion.

2.

As part of the management of a chain of convenience stores, you are contemplating opening (building) a new store in one of two cities, each located in a different state. Each store would have a projected payback in five years, before taxes. What state and local taxes should be considered? How might they be influential in making the choice?

3.

One of your company’s manufacturing plants is located in the suburbs of a major city. A new manufacturer’s tax credit has been put, by the state government, which is based on in place for hiring in the central part of the same city. In addition to interest free construction loans offered for construction in this area, the credit would bring operating costs to one-half of those in the current suburban location. Using the SAVANT framework, discuss the important issues that are relevant.

4.

After scouting a number of locations, your financial analysts have settled on a desirable location for one of the firm’s new manufacturing plants. However, the state income and local property taxes are much higher than those of surrounding areas. What might you tell local officials to convince them they should provide significant tax holidays?

2

Commented [h1]: Statement is unclear

PROBLEMS (Refer to the corresponding Concept Application) 1.

Assume the firm has $100 million of combined (consolidated) taxable income, with data by state as follows ($millions):

Sales Property Payroll Corporate tax rate

California 100 50 20 9%

Illinois 50 30 10 7%

New York 150 45 15 10%

The proposed plant would have net income, sales, property, and payroll of ($millions): 10, 40, 30, and 10, respectively. Assume corporate tax rates in Nevada and Texas of zero and 2.5%, respectively. Assume property taxes of about 1.5% in Nevada, 2% in Texas.

What is your recommendation, assuming a cost of capital of 10%?

2.

Assume land and construction costs of $1 million in either state and tax structures for the two locations as follows: State Corp. tax rate Local rate property tax Projected pretax net income (annual)

City 1 5% 2.00% $300,000

City 2 10% 1.20% $400,000

What is your recommendation to management, assuming an 8% cost of capital?

3.

Suppose, if you sold the old factory, the firm would net (after taxes and other transactions costs) $30 million. The cost of building the new inner-city factory would be $50 million.

Annual projected operating data would be ($millions): Sales

$10

Payroll

5

Other expenses

2

Property taxes at (1.5%) would be forgiven for 10 years. Payroll, which is inner city (80% for this plant), is eligible for a 75% tax credit on the firm’s state income taxes. The state corporate income tax rate is 8%. Assuming the firm’s cost of capital is 10%, what is your recommendation to management?

4.

Suppose the annual property taxes on the new plant would be $5 million, while comparable taxes in another county would be $2 million. Assume that after considering the ripple through (multiplier) effect, sales in the local area would increase by $15 million, and new payroll would be around $5 million. Assuming a 10-year investment horizon, what would you recommend to management?

3

MINICASE: BUZZ, LLC Buzz, LLC operates a highly successful chain of coffeehouses. Located primarily next to college campuses in the Boston area, the chain specialized in high caffeine coffee at a low price, tables amenable for studying, and modern decor appealing to college undergraduates. It is considering opening some stores in other large cities with a large number of students: San Francisco, Los Angeles, Chicago, Dallas, and New York. Because the initial investment in any one house is $1 million, and the limited liability company does not have access to public market financing, it wants to pick just one location as a test market. State income tax rates in California, Illinois, Texas, and New York are 9%, 7%, 2%, and (with city income tax) 10% respectively. The Massachusetts houses were paying an effective state tax rate of 11%. Discuss what additional information would you need?

Assume the following ($thousands):

Sales Payroll Property Net Income

Massachussetts Houses 20,000 1,500 10,000 2,500

New House 2,000 150 1,000 100

Property taxes are about 1.5% in each state, and the firm’s cost of capital is 10%. What would you recommend to management?

4

COMPREHENSIVE STRATEGY CASES: COMPUCO and DATASERVE (PART 5) Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

5

COMPUCO, INC. “Well, it looks as though we’ve reached an impasse” said Jim Bates, folding his arms across his chest. Bates was the founder and Chief Executive Officer of California-based Compuco, and he owned 20% of the company’s 5 million publicly traded shares. Although hard driving, Bates frequently let his talented group of managers reach a consensus without imposing his will. This time might have to be an exception. He couldn’t get them to agree on this transfer pricing thing, and some agreed-upon price had to be decided soon because computers needed to be sold.

The impasse was on the price that Comcirc U.S. should charge Comcirc S.A. (Mexico) for circuit boards. Comcirc US made the boards in New York, and then shipped them to Mexico where Comcirc S.A. used them as components in making computers, which they sold on a worldwide market. Both subsidiaries were owned 100% by Compuco, Inc. The sub was located in Mexico due to favorable labor markets and due to the tax rate of 25%, much lower than the 34% faced in the United States. It had been in operation for a month now and things seemed to be running smoothly except for the transfer price issue.

“Joan, why don’t you summarize where we are at this point to make sure Jim and Dave both have all the facts straight” said Bates. Joan Chavez was his Chief Financial Officer and he knew from the way she had handled the company’s re-engineering efforts that she could tactfully deal with managerial turf wars. Jim McMullen and Dave Stern were the presidents of the Mexican and U.S. subsidiaries, respectively.

Chavez began. “When we originally started Comcirc S.A. we envisioned some tax minimization. We wanted to set the transfer price as low as possible, to minimize U.S. taxes.

The important duty part of it seemed unimportant because NAFTA virtually eliminates them.

We hoped to set the price about 5% above our full costs to manufacture the boards. However, the Regulations under IRC sec. 482 recently went into effect, and now we are required (under the method) to charge well above a 5% markup.1 This will create a big effect a big effect on earnings. Right now, we use the same transfer price for tax external reporting, and internal purposes. The cost of creating new systems would run about $1 million.”

Stern jumped in. “The real problem is the profit-sharing plan for the nonmanagement employees. I’ve talked to the union people and it can’t be renegotiated. If we sell to S.A. at a low price our earnings drop and so does their share of company profits. And there’s the loan matter. Right now our bankers require a maximum debt equity ratio of five to one. If we depress earnings, we could fall below this, and they could call the debt.” He sighed. “On the other hand, maybe I’ll get lucky and they’ll just break my legs.”

Chavez interjected. “It’s apparent that that impasse will not go away by itself, and we need to resume production. I propose we sell Comcirc US immediately, and use the proceeds to buy another domestic board manufacturer. I’ve compiled a list of a number of companies we could acquire in states B through I. Although they are selling their output at certain prices, if we offered to buy any of them at 1.5 times sales (about 20% above market value), they would be willing to set the transfer price at their cost to manufacture plus 10%, a price I think we can

1

Under this method, the inter-company transfer price would need to approximate the sales price to outside parties.

6

justify under 482. Of course, we would keep Dave on as the CEO of the new company.” She paused to let this all sink in.

“Sounds intriguing. Go on” said Bates.

“They vary in size, in the target firms’ profitabilities, and there are the related state tax rules.

We should consider all state taxes; assessed value for property taxes is likely to be 80% of the purchase price. In terms of production, we can buy any plant, or combination of them, so long as they at least replace S.A.’s production. Any excess production can be sold on the market at its original sales price.”2 Chavez paused to let the additional information take effect, and then went on: “A few other things are relevant. First, we could net an after-tax cash flow of $20 million on the sale of Comcirc US. Any additional funds necessary to acquire board manufacturers would be through debt, at a pre-tax cost of 8%. And/or, we could sell off the restaurant subsidiary (our only other sub), at a net of tax profit of $20 million. The problem is that this sub throws off $5 million annually in tax net operating losses (NOLs) from its state a location. Also, our main competitor, Countel, owns companies A and F. We can acquire them for additional strategic advantage, are the only two potential targets with NOL carryforwards, estimated at $500,000 each.”

Bates broke in. “How will the divestiture/acquisition plan affect our financials?”

“Our consolidated bottom line is $70 million right now, and our consolidated balance sheet shows $700 million in assets (90% of which, like industry standards, are P&E), and $490 million in liabilities. Incidentally, any of these targets would not require union or management contract renegotiations: total payroll costs, like our current operations, would be about 30% of cost of goods sold,” continued Chavez.

“Well, let’s sell Comcirc US and find the best way to replace it. Provide me a memo with supporting computations” declared Bates.

2

The states are as follows: A (Kansas); B (Kentucky), C (Louisiana), D (Massachusetts), E (Maryland), F (Maine), G (Minnesota), and H (Oregon). D and E are in separate reporting states.

7

Commented [h2]: Please spell out P&E

TABLE 1: COMPUCO (US PARENT) FINANCIAL DATA (in thousa nd of U.S. Dolla rs) 2001

2002

2003

2004

Ave ra ge 2001- 2004

Ave ra ge 2002- 2004

Asse ts

$372,500

$434,444

$439,035

$449,552

$415,326

$441,010

Sa le s (Ne t)

$289,000

$345,000

$385,000

$401,000

$339,667

$377,000

C o st o f G o o d s So ld

$125,100

$144,900

$184,800

$188,470

$151,600

$172,723

G ro ss Pro fit

$163,900

$200,100

$200,200

$212,530

$188,067

$204,277

O p e ra ting Exp e nse s

FINANCIAL DATA:

$119,200

$141,450

$150,150

172430

$136,933

$154,677

O the r Inc o m e

$5,360

$6,030

$7,102

$8,308

$6,164

$7,147

O p e ra ting Pro fit

$44,700

$58,650

$50,050

$40,100

$51,133

$49,600

56.71% 15.47% 131.02% 137.50% 12.00%

58.00% 17.00% 138.10% 141.46% 13.50%

52.00% 13.00% 108.33% 133.33% 11.40%

53.00% 10.00% 112.77% 123.26% 8.92%

55.37% 15.05% 124.05% 137.34% 12.31%

54.18% 13.16% 118.27% 132.07% 11.25%

KEY RATIOS: G ro ss Pro fit/ Sa le s O p e ra ting Pro fits/ Sa le s G ro ss Pro fit/ C O G S G ro ss Pro fit/ O p e x O p e ra ting Pro fits/ Asse ts

8

TABLE 2: COM CIRC (US SUB) FINANCIAL DATA (in thousa nd of U.S. Dolla rs) SUBSIDIARY 1 **LOCATED IN GEOGRAPHIC AREA A** FINANCIAL DATA:

2001

2002

2003

2004

Ave ra ge 2001- 2003

Ave ra ge 2002- 2004

Asse ts

$53,011

$66,936

$71,730

$85,199

$63,892

$74,622

Sa le s (Ne t)

$40,000

$45,000

$53,000

$62,000

$46,000

$53,333

C o st o f G o o d s M a nufa c ture d

$14,000

$14,400

$18,550

$18,600

$15,650

$17,183

G ro ss Pro fit

$26,000

$30,600

$34,450

$43,400

$30,350

$36,150

O p e ra ting Exp e nse s

$6,280

$6,570

$7,049

$4,464

$6,633

$6,028

O the r Inc o m e

$5,360

$6,030

$7,102

$8,308

$6,164

$7,147

O p e ra ting Pro fit

$19,720

$24,030

$27,401

$38,936

$23,717

$30,122

65.00% 49.30% 185.71% 414.01% 37.20%

68.00% 53.40% 212.50% 465.75% 35.90%

65.00% 51.70% 185.71% 488.72% 38.20%

70.00% 62.80% 233.33% 972.22% 45.70%

65.98% 51.56% 193.93% 457.56% 37.12%

67.78% 56.48% 210.38% 599.73% 40.37%

$11.10 $0.64 1,297,007 $44.88 $31.62 1,297,007

$12.39 $0.65 1,497,633 $45.78 $32.25 1,497,633

$10.83 $0.67 1,717,597 $46.69 $32.90 1,717,597

$11.80 $0.64 1,323,531 $44.89 $31.62 1,323,531

$11.44 $0.65 1,504,079 $45.78 $32.26 1,504,079

17,462,902 28,707,953 46,170,855 45,000,000 1,170,855

20,568,492 33,809,065 54,377,557 53,000,000 1,377,557

24,058,381 39,556,259 63,614,640 62,000,000 1,614,640

KEY RATIOS: G ro ss Pro fit/ Sa le s O p e ra ting Pro fits/ Sa le s G ro ss Pro fit/ C O G M G ro ss Pro fit/ O p e x O p e ra ting Pro fits/ Asse ts

UNIT DATA: Avg . M a nufa c turing C o st/ Unit $11.91 Allo c a te d G & A, Se lling Exp / Unit $0.63 Units Pro d uc e d 1,175,953 Unit Pric e to Unre la te d Pa rtie s $44.00 Unit Pric e to C o m c irc S.A. (M e xic o ) $31.00 To ta l Units So ld 1,175,953 FYI: Sa le s to unre la te d p a rtie s(30%) 15,522,580 Sa le s to re la te d p a rtie s(70%) 25,518,180 To ta l Sa le s 41,040,760 Ne t Sa le s (fro m a b o ve ) 40,000,000 Re turns 1,040,760

9

TABLE 3: COMCIRC SA (MEXICO) FINANCIAL DATA SUBSIDIARY 2

(in thousa nd of U.S. Dolla rs)

2001

2002

2003

2004

Ave ra ge 2001- 2003

Ave ra ge 2002- 2004

Asse ts

$128,111

$150,920

$148,893

$155,104

$142,641

$151,639

Sa le s (Ne t)

$87,600

$102,000

$115,000

$130,000

$101,533

$115,667

C o st o f G o o d s M a nufa c ture d

$36,792

$39,270

$49,450

$52,910

$41,837

$47,210

G ro ss Pro fit

$50,808

$62,730

$65,550

$77,090

$59,696

$68,457

O p e ra ting Exp e nse s

$30,660

$31,395

$31,395

$36,790

$31,150

$33,193

O p e ra ting Pro fit

$20,148

$31,335

$34,155

$40,300

$28,546

$35,263

58.00% 23.00% 138.10% 165.71% 15.73%

61.50% 30.72% 159.74% 199.81% 20.76%

57.00% 29.70% 132.56% 208.79% 22.94%

59.30% 31.00% 145.70% 209.54% 25.98%

58.79% 28.11% 142.69% 191.64% 20.01%

59.18% 30.49% 145.00% 206.24% 23.25%

$31.00 823,167

$31.62 907,905

$32.25 1,048,343

$32.90 1,202,318

$31.62 926,472

$32.26 1,052,855

123,475

136,186

157,251

180,348

138,971

157,928

FINANCIAL DATA:

KEY RATIOS: G ro ss Pro fit/ Sa le s O p e ra ting Pro fits/ Sa le s G ro ss Pro fit/ C O G M G ro ss Pro fit/ O p e x O p e ra ting Pro fits/ Asse ts UNIT DATA: Avg . Purc ha se Pric e Units Purc ha se d Unb ra nd e d b o a rd s so ld to unre la te d p a rtie s in G e o g ra p hic Are a B Avg . Pric e o f unb ra nd e d b o a rd s to 3rd p a rtie s in G e o . Are a B Units use d in p ro d uc tio n o r he ld in inve nto ry

FYI: Sa le s to 3rd p a rtie s in G e o . B To ta l Ne t Sa le s Sa le s re la te d to finishe d b o a rd s

$55.00

$61.60

$67.76

$75.21

$61.45

$68.19

699,692

771,719

891,092

1,021,970

787,501

894,927

6,791,129 87,600,000 80,808,871

8,389,041 102,000,000 93,610,959

10,655,359 115,000,000 104,344,641

13,564,599 130,000,000 116,435,401

8,611,843 101,533,333 92,921,490

10,869,666 115,666,667 104,797,000

10

TABLE 4: FINANCIAL DATA FOR CIRCUIT M ANUFACTURING COM PARABLE TARG ETS (in thousa nd of U.S. Dolla rs) 1998

1999

2000

2001

Ave ra ge 1998- 2000

Ave ra ge 2000- 2001

(g e o b ) Asse ts Sa le s C o st o f G o o d s M a nufa c ture d G ro ss Pro fit O p e ra ting Exp e nse s O p e ra ting Pro fit

$14,467 $10,412 $4,590 $5,822 $1,058 $4,764

$16,920 14856 $7,131 $7,725 $1,136 $6,589

$28,624 $19,699 $10,180 $9,519 $617 $8,902

$38,315 $26,425 $14,151 $12,274 $710 $11,564

$20,004 $14,989 $7,300 $7,689 $937 $6,752

$27,953 $20,327 $10,487 $9,839 $821 $9,018

KEY RATIOS: O p e ra ting Pro fits/ Sa le s G ro ss Pro fit/ C O G M O p e ra ting Pro fits/ Asse ts

45.75% 126.84% 32.93%

44.35% 108.33% 38.94%

45.19% 93.51% 31.10%

43.76% 86.74% 30.18%

45.04% 105.32% 33.75%

44.37% 93.82% 32.26%

Asse ts Sa le s C o st o f G o o d s M a nufa c ture d G ro ss Pro fit O p e ra ting Exp e nse s O p e ra ting Pro fit

$77,998 $53,250 $17,183 $36,067 $1,136 $34,931

$86,920 $64,856 $17,131 $47,725 $1,316 $46,409

$88,624 $69,699 $20,180 $49,519 $1,617 $47,902

$93,315 $76,425 $24,151 $52,274 $1,710 $50,564

$84,514 $62,602 $18,165 $44,437 $1,356 $43,081

$89,620 $70,327 $20,487 $49,839 $1,548 $48,292

KEY RATIOS: O p e ra ting Pro fits/ Sa le s G ro ss Pro fit/ C O G M O p e ra ting Pro fits/ Asse ts

65.60% 209.90% 44.78%

71.56% 278.59% 53.39%

68.73% 245.39% 54.05%

66.16% 216.45% 54.19%

68.82% 244.63% 50.97%

68.67% 243.27% 53.89%

Asse ts Sa le s C o st o f G o o d s M a nufa c ture d G ro ss Pro fit O p e ra ting Exp e nse s O p e ra ting Pro fit

$37,822 $25,325 $12,131 $13,194 $141 $13,053

$38,324 $30,532 $17,184 $13,348 $644 $12,704

$44,474 $35,250 $18,718 $16,532 $454 $16,078

$53,675 $40,469 $21,183 $19,286 $172 $19,114

$40,207 $30,369 $16,011 $14,358 $413 $13,945

$45,491 $35,417 $19,028 $16,389 $423 $15,965

KEY RATIOS: O p e ra ting Pro fits/ Sa le s G ro ss Pro fit/ C O G M O p e ra ting Pro fits/ Asse ts

51.54% 108.76% 34.51%

41.61% 77.68% 33.15%

45.61% 88.32% 36.15%

47.23% 91.04% 35.61%

45.92% 89.68% 34.68%

45.08% 86.13% 35.10%

FINANCIAL DATA: Compa ny A

Compa ny B

Compa ny C

- ge o C

- ge o d

11

TABLE 4 (c ontinue d) FINANCIAL DATA:

2001

2002

2003

2004

2001- 2003

2002- 2004

$116,325 $63,258 $22,147 $41,111 $12,227 $28,884

$145,934 $74,852 $24,185 $50,667 $17,350 $33,317

$179,092 $84,698 $24,796 $59,902 $17,976 $41,926

$172,680 $82,144 $23,654 $58,490 $18,601 $39,889

$147,117 $74,269 $23,709 $50,560 $15,851 $34,709

$165,902 $80,565 $24,212 $56,353 $17,976 $38,377

45.66% 185.63% 24.83%

44.51% 209.50% 22.83%

49.50% 241.58% 23.41%

48.56% 247.27% 23.10%

46.73% 213.25% 23.59%

47.64% 232.75% 23.13%

Asse ts Sa le s C o st o f G o o d s M a nufa c ture d G ro ss Pro fit O p e ra ting Exp e nse s O p e ra ting Pro fit

$30,244 $22,837 $11,106 $11,731 $48 $11,683

$33,782 $25,748 $12,257 $13,491 $66 $13,425

$46,706 $29,247 $13,247 $16,000 $993 $15,007

$46,753 $34,236 $14,104 $20,132 $1,291 $18,841

$36,911 $25,944 $12,203 $13,741 $369 $13,372

$42,414 $29,744 $13,203 $16,541 $783 $15,758

KEY RATIOS: O p e ra ting Pro fits/ Sa le s G ro ss Pro fit/ C O G M O p e ra ting Pro fits/ Asse ts

51.16% 105.63% 38.63%

52.14% 110.07% 39.74%

51.31% 120.78% 32.13%

55.03% 142.74% 40.30%

51.54% 112.60% 36.23%

52.98% 125.29% 37.15%

Compa ny G - ge o h Asse ts Sa le s C o st o f G o o d s M a nufa c ture d G ro ss Pro fit O p e ra ting Exp e nse s O p e ra ting Pro fit KEY RATIOS: O p e ra ting Pro fits/ Sa le s G ro ss Pro fit/ C O G M O p e ra ting Pro fits/ Asse ts

Compa ny H - ge o I

12

TABLE 5: DATA ON UNIT COST AND PRICE OF TARGETS Ave ra ge 2001- 2003

Ave ra ge 2002- 2004

$26,425 $24.00 1,101,042

$14,989 $23 658,555

$20,327 $23 867,811

$10,180 $5.96 1,708,054

$14,151 $6.02 2,350,664

$7,300 $5.84 1,243,857

$10,487 $5.93 1,761,325

$64,856 $34.00 1,907,529

$69,699 $35.00 1,991,400

$76,425 $36.00 2,122,917

$62,602 $34 1,837,522

$70,327 $35 2,007,282

$17,183 $5.77 2,977,990

$17,131 $5.83 2,938,422

$20,180 $5.95 3,391,597

$24,151 $6.04 3,998,510

$18,165 $5.85 3,102,669

$20,487 $5.94 3,442,843

Sa le s (in tho usa nd s) Pric e Units

$25,325 $31.00 816,935

$30,532 $32.00 954,125

$35,250 $33.00 1,068,182

$40,469 $34.00 1,190,265

$30,369 $32 946,414

$35,417 $33 1,070,857

C o st o f G o o d s M f'd (in tho usa nd s) M a ufa c turing C o st Units

$12,131 $4.35 2,788,736

$17,184 $4.33 3,968,591

$18,718 $4.31 4,342,923

$21,183 $4.31 4,914,849

$16,011 $4.33 3,700,083

$19,028 $4.32 4,408,788

Sa le s (in tho usa nd s) Pric e Units

$72,121 $53.00 1,360,774

$78,945 $55.00 1,435,364

$83,724 $56.00 1,495,071

$89,561 $58.00 1,544,155

$78,263 $55 1,430,403

$84,077 $56 1,491,530

C o st o f G o o d s M f'd (in tho usa nd s) M a ufa c turing C o st Units

$18,214 $6.25 2,914,240

$19,263 $6.30 3,057,619

$20,195 $6.30 3,205,556

$21,654 $6.35 3,410,079

$19,224 $6.28 3,059,138

$20,371 $6.32 3,224,418

UNIT DATA: Compa ny A

2001

2002

2003

2004

Sa le s (in tho usa nd s) Pric e Units

$10,412 $22.00 473,273

$14,856 $23.00 645,913

$19,699 $23.00 856,478

C o st o f G o o d s M f'd (in tho usa nd s) M a ufa c turing C o st Units

$4,590 $5.75 798,261

$7,131 $5.82 1,225,258

Sa le s (in tho usa nd s) Pric e Units

$53,250 $33.00 1,613,636

C o st o f G o o d s M f'd (in tho usa nd s) M a ufa c turing C o st Units

Compa ny B

Compa ny C

Compa ny D

-

-

-

-

13

TABLE 5 (c ontinue d) UNIT DATA:

2001

2002

2003

2004

2001- 2003

2002- 2004

Sa le s (in tho usa nd s) Pric e Units

$118,721 $44.00 2,698,205

$125,896 $45.00 2,797,689

$138,745 $46.00 3,016,196

$155,668 $47.00 3,312,085

$127,787 $45 2,837,363

$140,103 $46 3,041,990

C o st o f G o o d s M f'd (in tho usa nd s) M a ufa c turing C o st Units

$45,321 $6.25 7,251,360

$46,192 $6.30 7,332,063

$52,512 $6.30 8,335,238

$60,216 $6.35 9,482,835

$48,008 $6.28 7,639,554

$52,973 $6.32 8,383,379

Sa le s (in tho usa nd s) Pric e Units

$34,532 $64.00 539,563

$41,258 $66.00 625,121

$45,138 $69.00 654,174

$52,155 $71.00 734,577

$40,309 $66 606,286

$46,184 $69 671,291

C o st o f G o o d s M f'd (in tho usa nd s) M a ufa c turing C o st Units

$13,107 $6.45 2,032,093

$18,204 $6.55 2,779,237

$19,248 $6.65 2,894,436

$21,226 $6.73 3,153,938

$16,853 $6.55 2,568,589

$19,559 $6.64 2,942,537

Sa le s (in tho usa nd s) Pric e Units

$63,258 $39.00 1,622,000

$74,852 $40.00 1,871,300

$84,698 $41.00 2,065,805

$82,144 $43.00 1,910,326

$74,269 $40 1,853,035

$80,565 $41 1,949,143

C o st o f G o o d s M f'd (in tho usa nd s) M a ufa c turing C o st Units

$22,147 $5.75 3,851,652

$24,185 $5.80 4,169,828

$24,796 $5.85 4,238,632

$23,654 $5.87 4,029,642

$23,709 $5.80 4,086,704

$24,212 $5.84 4,146,034

Sa le s (in tho usa nd s) Pric e Units

$22,837 $48.00 475,771

$25,748 $49.00 525,469

$29,247 $51.00 573,471

$34,236 $52.00 658,385

$25,944 $49 524,904

$29,744 $51 585,775

C o st o f G o o d s M f'd (in tho usa nd s) M a ufa c turing C o st Units

$11,106 $4.95 2,243,636

$12,257 $5.00 2,451,400

$13,247 $5.00 2,649,400

$14,104 $5.05 2,792,871

$12,203 $4.98 2,448,145

$13,203 $5.02 2,631,224

Compa ny E

-

Compa ny F -

geo f

Ge o. g eBo g

Compa ny G -

geo h

Compa ny H -

14

DATASERVE (PART 5) Refer to the original case in Chapter 3. Assume the firm is a C corporation. Statistics, as follows ($thousands): After careful deliberation, Jimmy and Roman have decided to expand their services to nearby cities. The cities are across the state border; each is in a separate state. Since both of these cities are in different states, they are concerned about the income tax consequences. Except for such consequences, the two alternative locations would have comparable operating costs: Projected revenues

City A 700

City B 680

Projected operating costs1 Net Assets Payroll State tax rate

300 400 400 150 9%

280 400 350 150 4%

1. Before interest. Assume that financial and tax accounting rules are identical; for example, straight line depreciation for both book and tax. Assume DataServe’s 2004 payroll is $200k.

State A, where city A is located, imposes a so-called separate accounting system, whereby only income earned in the state is subject to tax. State B, however, is a unitary state, whereby all affiliates are included in the tax base. Both states double-weigh sales in employing the three factor formula. Dataserve is currently located in State C, also a unitary state, with a corporate tax rate of 8%. All three locations have local property tax rates of 1%.

Jimmy and Roman are looking for advice as to which location to chose. Either would be organized as a separate corporation. Both expect a 10% per annum growth rate. Assume a 10% cost of capital. Assume investments in assets, and hiring of new employees, would be financed through 10% debt, secured by the assets.

15

STRATEGIC BUSINESS TAX PLANNING Chapter 8 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

A medium-sized U.S. manufacturer of designer clothing does most of its operations in California and Texas. A rival firm has just relocated one-half of its production in Shanghai. Currently, the Chinese government offers 15% tax rates, extremely low wage rates, and other advantages that would cut production costs by half. The Chinese government would probably insist on a 20% ownership as a joint venture. Comment on the possibility of relocating.

2.

Your firm makes high-end designer watches designed to compete with such brands as Rolex. Your customers and manufacturing are U.S.-based, but you would like a strategic presence in Europe. You have selected Ireland and Germany as your two European manufacturing sites. The Irish (German) plants will probably operate at positive (negative) income for the first five years. Comment on whether to operate as a branch or a corporation.

3.

A U.S. shoe manufacture, based in Texas, has just established a plant in Juarez, Mexico.

The finished goods would be transferred to the U.S. plant, and resold in the U.S. market.

The U.S. and Mexican tax rates are 35% and 25%, respectively. The Mexican plant has $20m of taxable income per year. The U.S. parent has a net operating loss (NOL) carryover of $50m, which will expire in two years. Managers in both operations are evaluated on after-tax earnings per share (EPS). Discuss possible transfer price strategies.

2

PROBLEMS (Refer to the related Concept Applications) 1.

Suppose you have gathered the following information: Current Plants Proposed California & Texas Production (units) Net income

Shanghai Plant 500,000

500,000

$2.4m

$4m

5%

N/A.

National tax rates

35%

15%

Cost of relocating

N/A.

$1m

State tax rates (average)

What is your recommendation?

2.

The following data pertains to current and proposed operations: Proposed U.S.

Production (units)

Irish

German

10,000,000

2,000,000

2,000,000

$100m

$30m

$<5>m

Branch tax rates

N/A.

0

Corporate tax rates

35%

Startup costs

N/A.

Net income

0 30%

$3m

$2m

What is your entity choice decision for the two new operations? How would this change if the U.S. operations, instead of having positive taxable income, had a NOL carryover (into the next year) of $65m?

3.

Assume the following feasible range of transfer prices, costs, and sales prices:

Cost to manufacture

US Plant

Mexican Plant

N/A.

$75/unit

Sales price to outside customers

$300/unit

Number of units

500,000

500,000

$35m

$20m

Taxable income, assuming $150 transfer price before NOL carryover

Reasonable range of transfer prices per unit is $120 to $200. 75% of management compensation is tied to after-tax earnings per share. What is your transfer price recommendation?

3

MINICASE You are Chief Financial Officer for Charge, Inc., a manufacturer of soft drinks. Although the firm has a number of products, its most popular is Charge, a high caffeine cola popular with generation X consumers. All of your markets have been domestic, but your research indicates a high likelihood of success in urban, youthful cities in Europe. Current and projected operations are:

Sales revenue Net income Units (cans) transferred per year Tax rate

Current U.S. $100m 30m 100m 35%

Proposed Facility Lyon (France) $30m 20m 30m 30%

The above assumes that unit equivalents (in liquid form) are transferred overseas at $10 per unit. Acceptable transfer prices range from $.05 to $.40 per unit. Ten key executives would be transferred to Lyon; their salaries would be $200,000 each, plus 1% of after-tax net income.

Assume the executives are in the 36% bracket for both French and U.S. purposes. Do you recommend greenlighting the project, and if so, what planning can be done within the SAVANT framework?

4

COMPREHENSIVE STRATEGY CASES: DATASERVE (PART 6) and COMPUCO (PART 2) Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

5

DATASERVE (PART 6) Refer back to the original Dataserve case in Chapter 3. Assume the firm is a C corporation.

Jimmy and Roman were trying to decide between two new office sites, one located in the United States, the other in Canada. The city on the U.S. side of the border was virtually identical to its Canadian counterpart: medium sized, with similar costs and demand. Their estimates of operations in the two cities were as follows ($thousands):

Projected revenues Projected operating costs Net Assets Payroll

U.S. City Site 700 300 400 400 150

Canadian City Site 680 280 400 350 150

Although no one at Dataserve was a Canadian citizen, many of them had visited this particular city and had strong business contacts.

Another choice needed to be made was entity: there was even sentiment between a separate subsidiary corporation, and a branch. Either way, the new venture would be capitalized by 10% borrowing by Dataserve. And the new operation would be either a separately incorporated corporation, or a branch.

Assuming a growth rate of 15% and a cost of capital of 10%, make a recommendation to Jimmy and Roman. Assume a Canadian tax rate of 34%; ignore state, local, and provincial taxes.

6

Compuco, Inc. (Part 2) “Well, it looks as though we’ve reached an impasse” said Jim Bates, folding his arms across this chest. Bates was the founder and Chief Executive Officer of California-based Compuco, and he owned 20% of the company’s 5 million publicly traded shares. Although hard driving, Bates frequently let his talented group of managers reach a consensus without imposing his will. This time would have to be an exception, however. He couldn’t get them to agree on this transfer pricing thing, and some agreed-upon price had to be decided soon because computers needed to be sold.

The impasse was on the price that Comcirc US should charge Comcirc S.A. (Mexico) for circuit boards. Comcirc US made the boards in New York, and then shipped them to Mexico where Comcirc S.A. used them as components in making computers, which they then sold on a worldwide market. Both subsidiaries were owned 100% by Compuco, Inc. The sub was located in Mexico due to favorable labor markets and due to the tax rate of 25%, much lower than the 34% rate faced in the States. It had been in operation for a month now and things seemed to be running smoothly except for the transfer price issue.

“Joan, why don’t you summarize where we are at this point just to make sure Jim McMullen and Dave Stern both have all the facts straight” said Bates. Joan Chavez was his Chief Financial Officer and he knew from the way that she had handled the company’s reengineering efforts that she could tactfully deal with managerial turf wars. McMullen and Stern were the presidents of the Mexican and U.S. subsidiaries, respectively.

Chavez began. “When we originally started Comcirc S.A. we envisioned some tax minimization. We wanted to set the transfer price as low as possible, to minimize U.S. taxes.

The import duty part of it didn’t seem important because we figured NAFTA would eventually pass. We hoped to set the price about 5% above our full cost to manufacture the boards. Two problems have cropped up. The first is the impact of the new IRS regulations on transfer pricing. We must use the “cost-plus” method, which will result in a transfer price of $36.26.

The second problem is the effects of earnings. Right now in our accounting system transfer prices used for tax are also used internally and for our financials. The cost of creating separate systems would be about $1 million.”

Stern jumped in. “The real problem is our profit sharing plan for the nonmanagement employees. I’ve talked to the union people and it can’t be renegotiated. If we sell to S.A. at a low price our earnings drop and so do their shares of company profits. And there’s the loan matter. Right now our bankers require a maximum debt to equity ratio of five to one. If we depress earnings we could fall below this, and they can call the debt” He sighed. “On the other hand, maybe I’ll get lucky and they’ll just break my legs.”

The humor was lost upon the group. McMullen then spoke up. “The earnings problem is tough at our end. To entice my managers to move we offered them a bonus plan tied to S.A.’s earnings. Any plan which lower the proposed cost plus 5% plan would make them P.O.’d big time. They might quit.”

Bates looked around the room. He was reminded of the look on his son’s face when he had opened a birthday gift only to discover that the toy was broken. He didn’t have to mention the additional stock market problem. Compuco’s shares were now trading at $55 (down from $65) when an analyst found out about the pricing stalemate.

7

An alternative plan was proposed Kay Smith, the VP of Finance. She proposed that they simply sell S.A. and replace it with one of a comparable firm in another country. At this point, they were limiting their choices to geographic areas A and F, B, C, and E; Ireland, the U.S., China, and Brazil. Smith had gathered the following information on each:

Corporate Tax Rate

Other Taxes: VAT Other Incentives

Commented [h1]: 5 areas but 4 countries given Commented [h2]: 4 countries but 3 listed below, is that correct?

Ireland

China

Brazil

38%

30%

(10% if in designated area)

(15% if in special districts)

25%; 18% on income > $860K

21% on exports

17% imports

18% imports;

0% exports

0% exports

For high tech joint ventures with Chinese companies, no tax for two years

Various grants for certain areas

Various grants, loans in designated areas

So, the decision was: sell, or retain S.A. and get a new transfer price? If sell, where to buy the new plant? Smith noted that Compuco’s major rival, Countel, used companies A and F as its principle supplier. Also, its restaurant subsidiary could be sold ($40m, net for its plus S.A.), proceeds used to reduce borrowing required for the new overseas investment.

Note: Refer back to Compuco case (Chapter 8) for financial data. Ignore the narrative in the original Compuco case, and instead assume the above narrative. Ignore state and local tax consequences.

8

COMPUCO, INC AND COMCIRC Notes and Assumptions 1. Comcirc US produces circuit boards for personal computers and some minor peripheral byproducts.

2. All data provided in Tables 4 and 5 meet the comparability provisions (e.g., functions, risks, etc.) of the temporary Treasury regulations unless information is provided to the contrary.

3. Each year, Comcirc US sells 70% of its production output to Comcirc S.A. (Mexico) which is in Geographic Area B. The remaining units (i.e., 30%) are sold to various unrelated third parties “as is” in Geographic Area A. 4. A volume discount is accorded to Comcirc S.A. (Mexico). The discount is offered to all parties by Comcirc US provided the buyer purchases lots greater than 750,000 units. In all years listed, the unrelated third parties have not taken advantage of the offered discount. All other economic circumstances are substantially the same.

5. Comcirc S.A. (Mexico) buys 100% of its circuit board components from Comcirc US. Comcirc S.A. (Mexico) uses 85% of the circuit boards in its assembly of computers, which it sells to unrelated distributors. The remaining 15% of the unbranded circuit boards are sold to other manufacturers in Geographic Area B at the current market price.

No “substantial value” has been added to these unbranded boards.

6. Mexico’s corporate tax rate is fixed at 25% of Operating Profits (i.e., there are no adjustments required to determine taxable income).

7. Comcirc U.S. sells circuit boards to unrelated distributors at a mark-up that ranges from 60 to 80%.

8. Comcirc US allocates a small percentage of its General & Administrative as well as selling expenses to these third parties, but none of these costs are allocated to Comcirc S.A. (Mexico).

9. All financial data of comparable companies have been adjusted to compensate for accounting differences.

9

STRATEGIC BUSINESS TAX PLANNING Chapter 9 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

Your firm manufactures toy cars and trucks. Although sold on a nationwide basis, all manufacturing occurs in its only plant, in Iowa. Your sole competitor, who manufactures in Texas, is considering purchasing its materials from Mexico. You have considered purchasing your components from India (currently you purchase from Iowa suppliers).

What should you consider before making such a move?

2.

As Chief Financial Officer of a consumer electronics firm, you have recently been made aware that if your firm switches from FIFO to LIFO, it might save millions annually in income taxes. What factors should you consider before making such a decision?

3.

In considering how many units to manufacture (purchase) and sell (resell), how do taxes affect the decision?

4.

Suppose you are attempting to budget production worker-hiring, and machine acquisitions, for the next five years. Your firm operates in a number of states and overseas. How would strategic tax planning be utilized here?

2

PROBLEMS (Refer to the related Concept Applications) 1.

A comparison of cost data for the two is as follows:

Cost of material per completed car or truck Delivery time Import duty

Iowa Suppliers

India Supliers

$10 1 day N/A

$4 2 weeks $0.50

What is your recommendation to management?

2.

The firm’s income statement is as follows ($thousands) Sales Cost of goods sold Gross margin Selling, general, and administrative expenses NIBIT Interest Taxes Net Income

$1,200 500 700 300 400 200 100 $100

Assume that ending inventory is $1,800 under FIFO, but would be $1,400 under LIFO, if the conversion is made. Assuming management receives one-half of their compensation in the form of a year-end bonus, based on the firm’s net income, what would you recommend? Assume a 10% cost of capital.

3.

In considering production decisions, Owens Corning Company recently installed SAP. This information system connects all the information that flows through a company in a single system. For example, when a sales person places an order, the system automatically locates raw materials, schedules production and delivery, and prepares a bill. Planning becomes easier; inventory can be minimized, with customers able to get reliable, faster service. If you had been a consultant advising Owens on whether to acquire SAP, would you have done so?

Assume the following: Cost of system (eligible for five years MACRs depreciation)

$100 m

Annual cost savings in inventory carrying costs

10 m

Annual savings in property taxes on lower year-end inventories 10 m

3

Annual sales increase due to new customers (assume 30% profit margin)

20 m Commented [h1]: Is this part of Problem 3?

Assume a 10% cost of capital, and that the firm prefers a five year payback on all projects.

4.

Commented [h2]: What is the problem here?

Assume operating and financial statistics as follows: Financial ($mil) Sales Cost of goods sold Gross profit Operating Expenses Interest Taxes Net Income

Illinois $10.0 7.0 3.0 1.0 .1 .8 .1

South Carolina $4.0 3.0 1.0 .5 .1 .1 .3

Toronto Canada $9.0 6.0 3.0 1.2 .1 1.1 0

Operating Units produced

100,000

50,000

75,000

Number of workers ( average annual wage)

1,000 ($25k)

800 ($15k)

800 ($30k)

Book value of machiner' (cost = $100k/machine)

$4 m

$2 m

$3 m

Production function P= .5 (L.4 K.4), for each plant

The company manufactures microwave ovens, and sells them to wholesalers located within the same state (province) where the factory is located. Assuming no transactions between the three factories, that labor and capital can be shifted between the three factories, and each factory can sell (at most) only its existing production at the existing price, how would you advise management to reallocate labor and capital, if at all? Assume five year straight line depreciation on equipment, and a 10% cost of capital. Actual economic life of the equipment is also five years.

4

MINICASE SLAM2, Inc. manufactures high-end tennis rackets. Made from graphite-titanium composites, the racquets are used by professionals, and also by high income amateurs. Selling for $400, about 50,000 units are sold annually. Annual demand is kept constant by continued product improvements.

After a recent trip to China, the firm’s Chief Executive Officer was impressed by the country’s infrastructure, and the number of U.S. firms with manufacturing plants there. Upon his advice, a team was sent to Shanghai where a factory site, in a “free trade zone,” would offer low income tax and tariffs rates for five years. The proposed site would replace the firm’s existing U.S. plant, with the following operating and financial statistics:

Cost of factory (current value) Number of workers (annual wage) Output (annual number of racquets produced)

Proposed Shanghai Plant $10 mil

Current U.S. Plant $8 mil (book value = $6 mil)

2,000 ($3000)

1,000 ($15,000)

50,000

Other Operating Expenses Local taxes U.S. taxes Property taxes Tariff (on import to U.S.)

5% 0% 0% 10%

S,G&A Raw materials

$2 mil $1 mil

50,000

8% 34% 1% of value N/A

$4 mil $2 mil

Question

Regarding taxes, the assumptions are: (1) No U.S. income taxes, since the earnings will remain in Shanghai for at least 10 years; (2) Chinese income taxes (tariffs) will remain at 5% (0%) for five years, after which time the normal rates of 25% (1% of value of goods) would occur; (3) Shanghai property taxes would revert to 1% of assessed value after five years; (4) The plant, like the U.S. factory, would be 20% land, 30% building, and 50% machinery (Chinese law requires five year straight line, unlike the seven-year MACRs used in the United States).

Delivery time to U.S. customers (sporting goods wholesalers) would go from 3 days to three weeks in the new location.

Because of delivery lags, 10% of annual inventory will have to be kept on hand at all times (unlike the 5% at the U.S. plant). At either plant, inventory is included in property tax values.

For the U.S. factory, one half of the operating costs must be charged to inventory under the Uniform Capitalization Rules (UCR). There is no comparable rule under Chinese laws.

5

Commented [h3]: The last two lines were not displayed on your version, should they be a part of the table or deleted?

Assume a 10% cost of capital, and a 10-year horizon. Assume that if the operations are switched to China, racquets would be sold to the U.S. parent for $390.

Using a quantitative analysis, what would you recommend to management?

6

COMPREHENSIVE STRATEGY CASES: DATASERVE (PART 7) and

ARMORWORKS Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

7

DATASERVE (PART 7) Refer back to the original Dataserve case at the beginning of Chapter 3. Assume the firm is a C corporation.

Jimmy and Roman have recently received a proposal from the Computer Science department of a nearby University to provide student workers. The students would work for $6 per hour, and would be graduate students with programming skills but little work experience. Compared to the $35,000 per year programmers which Dataserve currently employed, they seemed like a bargain. Payroll taxes and benefits (medical, dental, etc.) were about 10% of an average employee’s salary. The prospect of saving on such costs seemed inviting.

They estimated that the students would work at about half of the productivity of a full-time programmer. The full-time programmers worked 40 hour weeks, 48 weeks of the year. They worked without a contract. If some of them were replaced by students, Jimmy and Roman felt that least one full time programmer for every five students could be required in order to supervise the students.1 As an alternative to replacing full-time programmers, Dataserve could simply expand operations, using, in part, the students. Jimmy and Roman guessed that they could expand business by about 30%. Payroll, absent the use of part-timers, would increase proportionately.

The problem with expansion was the increasing probability of a “train wreck”; with decreasing amounts of their personal quality control, Jimmy and Roman felt that each 10% of business expansion increased the probability of a botched program by 1%. In their experience, such blow-ups typically cost the firm double the expected revenue. They discussed putting any business expansion into a separate legal entity, to limit such exposure.

1

Jimmy and Roman estimated that each programming hour roughly translated into $30 of product.

8

Commented [h4]: CS = Computer Science, please confirm

ARMORWORKS Armorworks was the largest U.S. manufacturer of armored military vehicles (tanks, armored personnel carriers, etc.). An old, established company, it had used FIFO for its inventories since inception. The president wants to switch to LIFO, for a number of reasons: ▪

It would reduce tax expense

▪

It seemed more conservative, and realistic from a reporting perspective

However, management was concerned about collateral earnings effects. Management compensation was 50% based on earnings; it was 10% of pre-tax earnings. Also, the stock market might adversely respond. Its major competitor had a tax net operating loss (NOL) carryforward which was not due to expire for several years. It was also on FIFO, and could switch. Armorworks’ switch was expected to result in a 20% decrease in ending inventory. The attached financials are sans-switch. Analyze from a SAVANT perspective.

Consolidated Statement of Earnings Year Ended December 31, 2004 (in Millions) Sales of Manufactured products Finance and insurance revenues Other revenues Total Revenues

$ 19,196 582 688 $ 20,466

Costs, other than items below Depreciation and special tools amortization Selling and administrative expenses Employee retirement benefits Interest expense Total Expenses

$15,281 771 1,577 471 336 $ 18,435

Earnings Before Income Taxes, Extraordinary Items, and Cumulative Effect of A Change in Accounting Principle Provision for income taxes

$ 2,031 791

Earnings before Extraordinary Item and Cumulative Effect of A Change in Accounting Principle Extraordinary Item - Loss on early extinguishment of debt, net of taxes* Cumulative effect of a change in accounting principle, net of taxes Net Earnings

$ 1,240 (64) ? $?

* Bonds redeemed early

9

Consolidated Balance Sheet Year Ended December 31, 2004 (In Millions) Assets: Cash and cash equivalents Marketable securities Total cash, cash equivalents and marketable securites Accounts receivable - trade and other Inventories Prepaid employee benefits, taxes and other expenses Finance receivables and retained interests in sold receivables Property and equipment Special tools Intangible assets Other assets Total assets

1,719 865 2,584 709 1,732 643 4,113 4,968 1,308 665 2,006 $18,728

Accounts payable Short-term debt Payments due within one year on long-term debt Accrued liabilities and expenses Long-term debt * (8%) Accrued noncurrent employee benefits ** Other noncurrent liabilities

$2,994 1,071 999 2,955 2,395 3,144 1,314 $14,871

Common stock Paid-in Capital Retained earnings Total Liab ilities and Equity

1,000 200 2,656 $18,728

Liabilities:

Equity:

Question

Commented [h5]: Where are the notes for the * and ** in the table?

10

Consolidated Balance Sheet Year Ended December 31, 2002 (In Millions) Assets: Cash and cash equivalents Marketable securities Total cash, cash equivalents and marketable securites Accounts receivable - trade and other Inventories Prepaid employee benefits, taxes and other expenses Finance receivables and retained interests in sold receivables Property and equipment Special tools Intangible assets Other assets Total assets

1,719 865 2,584 709 1,732 643 4,113 4,968 1,308 665 2,006 $18,728

Accounts payable Short-term debt Payments due within one year on long-term debt Accrued liabilities and expenses Long-term debt * (8%) Accrued noncurrent employee benefits ** Other noncurrent liabilities

$2,994 1,071 999 2,955 2,395 3,144 1,314 $14,871

Common stock Paid-in Capital Retained earnings Total Liab ilities and Equity

1,000 200 2,656 $18,728

Liabilities:

Equity:

Question

Commented [h6]: Where are the notes for * and **

11

Consolidated Statement of Earnings Year Ended December 31, 2002 (in Millions) Sales of Manufactured products Finance and insurance revenues Other revenues Total Revenues

$ 19,196 582 688 $ 20,466

Costs, other than items below Depreciation and special tools amortization Selling and administrative expenses Employee retirement benefits Interest expense Total Expenses

$15,281 771 1,577 471 336 $ 18,435

Earnings Before Income Taxes, Extraordinary Items, and Cumulative Effect of A Change in Accounting Principle Provision for income taxes

$ 2,031 791

Earnings before Extraordinary Item and Cumulative Effect of A Change in Accounting Principle Extraordinary Item - Loss on early extinguishment of debt, net of taxes* Cumulative effect of a change in accounting principle, net of taxes Net Earnings

$ 1,240 (64) ? $?

* Bonds redeemed early

12

STRATEGIC BUSINESS TAX PLANNING Chapter 10 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

Commented [h1]: No problems or minicases to follow?

CONCEPT APPLICATIONS 1.

A firm that owns and operates a chain of restaurants is considering replacing its aging kitchen equipment. What information would be important to know in advising on the timing of the acquisitions, if the choice is between this year and next year?

2.

A publicly traded hotel firm is considering financing the purchase of new hotels by internal funds. To do so, they will have to not pay dividends for two years. The firm has had a consistent dividend history of paying quarterly dividends of $2 per share on $25 par value shares. Discuss are there alternatives?

3.

A computer software company is highly profitable, and Microsoft has indicated it would like to acquire the firm. Management has no intention of selling. The firm’s 1 million shares (400,000 of which are owned by management) are trading for $120, and Microsoft has indicated it will tender $130 to shareholders. What financing methods can management use to fend off the takeover, and what are the tax implications?

4.

A skateboard manufacturer, headquarterered in California, has two manufacturing plants: one in Texas, and the other in Spain. Both are 100% owned, incorporated subsidiaries.

Both are also in need of major capital replacement. Each has sufficient cash to cover half of its capital needs. Management has decided that it will re-equip one of them, using the pooled funds. Discuss the situation from a SAVANT framework.

2

COMPREHENSIVE STRATEGY CASES: DATASERVE (PART 8) Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

3

DATASERVE (PART 8) Refer back to the original Dataserve case in Chapter 8. Assume the firm is a C corporation, and that Jimmy and Roman have decided to set up the new office site in the U.S. city.

Having decided on the location, Jimmy and Roman were faced with the decision of how to finance the $400,000 U.S. office. They weighted the following options: ▪

Use of retained earnings. If necessary, Jimmy and Roman would not pay any dividends to themselves.

▪

Short-term borrowing at 10%.

▪

Selling off raw land held by the corporation. It could be sold for $400,000. It had originally been bought by Jimmy for $20,000 in 1987. At the corporation’s formation, its fair market value was $100,000.

▪

Selling part of their stock back to the corporation.

4

STRATEGIC BUSINESS TAX PLANNING Chapter 11 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

You are Chief Executive Officer for a rental car company that operates in a single state.

Normally, you replace your fleet of cars every year. This year, you will withhold fleet replacement for an extra six months since you believe state tax rates will increase by 5%.

Comment on this.

2.

How would the fact that a firm has a net operating loss affect its capital budgeting strategy?

3.

In deciding whether to discontinue (and instead outsource) making a component, how should tax depreciation, which is part of the product’s overhead, be considered?

4.

Your firm has been looking at the possibility of building a new plant in either Mexico or Texas. Both local (city) governments have promised exemption from property taxes for at least five years. Discuss the merits of both locations from a SAVANT framework.

2

PROBLEMS (Refer to the corresponding Concept Application) 1.

Assume an average new car costs $20,000, and can be resold (on average) for $4,000 a year later. Demand for car rentals falls by 1% for each month the car exceeds the “brand new” stage. The company has a fleet of 100,000 cars, which rent for $40 per day on average, and each car is rented about 200 days per year. Maintenance costs are 20% per year of rental revenue. Assuming there is a 50% probability of a 5% tax rate hike, and the firm’s cost of capital is 10%, what do you recommend?

2.

A motel chain is considering rehabilitating a number of its aging hotels. Estimated average costs, for each of the 100 targeted motels, is $300,000 as follows: Reroofing Carpenting & drapes Furniture & fixtures Misc exterior, structural improvements

$50,000 100,000 100,000 50,000 $300,000

Management estimates the following: (1) Construction time is four months, during which each hotel’s average daily rental revenue of $5,000 would cease; (2) Demand would increase permanently by 10% after the improvements; and (3) The firm’s variable cost percent is 40%; local property taxes are 2% of value; and the firm’s net operating loss will expire in three years. Assuming a cost of capital of 10% and assuming a 10-year investment horizon, what would you recommend to management?

3.

A manufacturer of single-engine private airplanes manufactures its own engines.

However, it is finding that other companies can provide competitive prices on the engines, so it may make sense to discontinue manufacturing, and outsource. The engines can be purchased for $2,000 each. Currently, they are manufactured at a full absorption cost of $2,200, as follows: Direct labor Direct materials Overhead: Variable Fixed

1,000 200 $200 800

$1,000 $2,200

On further investigation, you find that fixed overhead is 50% from allocated general factory depreciation, and 50% attributable to equipment which would be sold if outsourcing occurred. Assuming the firm makes and sells 10,000 aircraft per year, its cost of capital is 10%, and it is in a combined federal and state 40% tax bracket, what would you recommend to management? Would your answer change if the firm currently has a NOL, which will expire in three years?

3

Assume financial and operating statistics for the two plants as follows: Financial Land cost Construction cost Equipment cost Annual cash operating costs: Salaries and wages Other Local income Local property tax rate Operating Production in units Probability of defective unit Transfer price to US parent

Texas Plant $1 mil 3 mil 1.5 mil

Mexico Plant $200k (99 year lease) 1.5 mil 1.5 mil

400k 300k 2.50% 3.00%

200k 150k 25% 1%

200,000 2% $10

150,000 5% $10

Texas (Mexican) authorities estimate that the plant would increase local tax collections, after considering the multiplier effect, by $100,000 ($40,000) per year. Assuming a cost of capital of 10%, what would you advise? Would your answer change if you believed that there was a 50% probability that the government would renege on its promise?

4

MINICASE Qualicare, Inc is an HMO serving several major metropolitan areas. It is considering opening a new hospital/outpatient center in a new city. Projected financial and operating statistics are: Financial Construction cost

$10 m

Land costs

5m

Equipment, furniture, fixtures costs

5m

Annual revenues Annual cash operating costs

9m 1.0 m

Operating Annual number of patient days (expected to grow 10%/year)

17,500

A number of other factors should be considered. There is a 30% chance that health care reforms/insurance company limitations will decrease revenues by 40%. Since the company was going to invest via cash, if it feels risk averse enough, it can instead invest the proceeds in financial markets at 10%. Also, the company can lease an alternative site from a bankrupt HMO for $500,000 per year. However, the other operating costs above would still be incurred.

Property taxes would be 2% annually. However, if the hospital agrees to hire at least 50 local area employees, officials have verbally agreed to reduce the rate to 1% for five years. The state is contemplating a 1% sales tax on services; there is a 20% chance it will occur.

5

The abbreviated financials for Qualicare (without the new hospital) are: Income Statement ($M) Revenues Operating Costs: Materials Salaries & wages S, G&A Depreciation Ebit Interest Taxes (federal, state) NI

$20.5 2.0 5.0 1.5 3.5 8.5 6.5 1.0 $.5

Balance Sheet ($M) Assets: Cash Marketable securites Accounts receivable Property, plant, and equipment

Liabilities & Equity: $10.0 20.0 3.5

Accounts payable Bonds payable Common stock Retained earnings

110.5

$5.5 88.0 20.5 31.0 $144.00

$144.00

What is your expectation as to the best decision: construct, lease, or invest in marketable securities?

Assume a 10% cost of capital, and a 10-year investment horizon.

6

COMPREHENSIVE STRATEGY CASES: DATASERVE (PART 9) and BILLYWORLD Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary.

7

Commented [h1]: Original is “SALT”, please confirm it’s correct

Dataserve (part 9) Jimmy and Roman are considering replacing their computer equipment. Although only 1 ½ years old, new, cutting edge workstation equipment, with more RAM, faster coprocessing, and more data storage is available. Given the nature of their business, they felt that such cutting edge equipment was essential. SUN Microsystems was offering a lease or purchase on $1 million of equipment.

The lease would be for five years, with equal monthly payments that included a 12% APR. A $100,000 down payment was required. For a purchase, Dataserve could get 13% bank financing. Alternatively, they could issue $1 million in debentures in a private placement, at 9%, payable in 10 years. The equipment had an economic life of five years; realistically, however, Dataserve would probably replace it in two years.

The new equipment would provide for development of cutting edge software, with which Jimmy and Roman could increase revenues anywhere from 10 to 30%. This might make the company more attractive to investors, which, since they were considering an initial public offering (IPO) the following year, was important.

Assuming a 10% cost of capital and a five-year horizon, evaluate the equipment acquisition proposals.

8

BILLYWORLD Billyworld was an amusement park company. 51% of the firm’s shares were owned by its founder and Chief Executive Officer, Billy Birkewicz.

Billyworld was considering building a new mini theme park in a middle American city. The mini theme park would be housed inside a currently vacant municipal civic center building. The center (80% of the value is attributable to the building) could either be purchased for $300 million, or leased over 20 years for $28 million per year. Other projected statistics were: Projected annual revenue

$80 million

Projected annual cash operating costs

$20 million

Cost of building amusement park equipment

$200 million

The above, were of course, just estimates: Billyworld had never developed a mini theme park. They are concerned about tax management. The company is in the 35% (8%) federal (state) tax bracket. All of the firm’s amusement parks, including the proposed mini theme park, would be in the same state.

Below are the firm’s current financials.

Applying quantitative analysis, what do you recommend to management?

Consolidated Statement of Earnings Year Ended Dec. 31, 2004 (In Millions) Revenues Costs and Expenses Accounting Change Operating Income

$9,370 (7,703) (150) 1,517

Corporate Activities and Other Interest Expense Investment and Interest Income Acquisition -related Costs

(155) (240) 21 (113)

Income before income taxes Income taxes Net Income

1,031 (424) 607

Net earnings per share

$.098

9

Consolidated Balance Sheet For Year Ended December 31, 2004 (In Millions) Assets Current Assets: Cash and cash equivalents Investments Receivables Inventories Film and television costs Theme parks, resorts and other property, at cost Attractions, buildings and equipment Accumulated depreciation Projects in process Land Intangible assets, net Other assets Total Assets Liabilities and Shareowners' Equity Accounts payable and other accrued liabilities Income taxes payable Borrowings Unearned royalty and other advances Deferred income taxes Stockholders' equity Preferred stock Common stock Retained earnings Cumulative translation and other adjustments Less treasury stock, at cost Total Liabilities and Shareowners' Equity

139 227 1,672 476 1,956 5,510 (2,224) 3,286 671 59 4,016 8,989 1,180 $18,653 3,187 291 6,171 590 372

4,288 3,967 20 8,274 (231) 8,043 $18,653

10

STRATEGIC BUSINESS TAX PLANNING Chapter 12 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

A beer manufacturer is considering whether to discontinue making one of its beers.

Although it accounts for 30% of the company’s sales, and is the most well-known of the firm’s beers, it incurs a consistent loss every year. After removing allocated (noncontrollable) costs from the analysis, the product line runs a $20 million per year ($30 million per year) financial (tax) loss, which compared the remainder of the firm’s financial (taxable) income of $50 million ($40 million), is substantial. What would you consider in making a decision?

2.

How would your decision above be changed by the following (consider each independently): a. The segment reduces both conglomerate financial and taxable income to negative amounts; b. 90% of the segment’s loss (both financial and tax) is attributable to depreciation; c. The rest of the firm, without considering the segment, already incurs a loss (both financial and tax)

3.

Suppose your firm operates in an industry where, although there a number of smaller firms, your major competitor is another large multinational firm. You are considering plant expansion, additional R&D spending, and an aggressive advertising campaign.

These substantial capital outlays are a heavy drain on cash flow, and require additional bond issuances. The cost is effectively decreased by the fact that you are in the 50% tax bracket (federal, state, and international).

Before you green light the plan, you are interested in your competitor’s likely strategic response. Your firm’s accountants have accessed the competitor’s 10k report, which reveals the following from the tax note and other parts of the financials: o

The firm has a net operating loss (NOL) carryforward, which by your accountants’ best estimates, will expire in two years.

o

Its debt: equity ratio is more than twice that of your firm, at 5:1.

o

Its overseas operations indicate an excess foreign tax credit situation. The foreign subsidiaries have large accumulations of undistributed cash.

o

It is R&D (advertising) budget has consistently been 5% (4%) of sales over the last five years.

Although these numbers are similar to yours, the proposed plan would double these figures.

What factors would you consider in your decision? What is your intuition as to your likely decision?

4.

Your firm makes candy bars which are sold on a national market. Suppose California and New York are contemplating a “snack tax” which would impose a 6% sales tax on them. If the legislation passes, you believe other states will likely follow suit. Although the tax is paid by the consumer you are convinced that there would be three negative firm impacts: (1) Price elasticity would cause a demand drop of 1%; (2) An accounting system would reduce profits by $150,000; and (3) Since vending machine prices could not easily be changed, the firm would take the hit for these taxes. Together, lost profits could be $10 million annually.

2

You have contacted a lobbyist, who, based on experience, believes that each $10,000 spent on lobbying reduces the probability of enactment by 1%. Assume the firm is in the 50% (combined federal, foreign, and state) tax bracket, and has a 10% cost of capital.

What is your decision?

3

PROBLEMS (Refer to the corresponding Concept Application) 1.

Assume the following operating information ($millions):

Sales Cost of goods sold Gross margin

Combined

Corporate Headquarters

Major Beer

All Other Beers

1000 550 450

0

300 150 $150

700 400 300

10 10 10 <30>

120 <20> 30 20

Other Expenses S,G &A Taxes Depreciation Segment margin

230 60 90 70

100 70 50 80

On further investigation, you discover that other expenses are 10% allocated from headquarters. Assuming a 10% cost of capital, after a quantified analysis, what would you recommend to management?

2.

a. Assume cost of goods sold of $300 million Commented [h1]: Please spell out S,G&A

b. Reverse the above S,G&A and depreciation numbers, that is, S,G &A = $30m, and depreciation = $120m. c. Assume an $80 m loss for the “all other beers” segment.

Assume the firm’s accountants gathered the following information:

3. o

There is a $2 million NOL carryover. In two years, it will expire, at which point the firm will be in the 50% (federal, state, and foreign) tax bracket.

o

Relevant sections of yours and your competitors’ balance sheet are ($millions): Bonds payable Equity: Common stock Retained earnings

Yours 50.5 11.0 30.5

Competitors 75.4 10.5 5.1

Under industry-standard bond covenants for both firms, if the debt: equity ratio exceeds 6:1, the debt is due and payable immediately.

4

o

The competitors’ overseas subsidiaries have, in total, $20 million in cash which could be repatriated. Withholding taxes in the related foreign countries are 15% on average.

o

Sales (net income) is $100 million ($20 million) for you; for your competitors it is $120 million ($12 million). Sales in the industry have grown 8%/year over the last five years, on average.

o

30% of management compensation, for both firms, is tied to earnings

What is your recommendation?

4.

Sales are ($millions):

California New York All other markets

Vending Machines $10 $5 $150

Other Retail $15 $20 $160

The gross profit percent is 70% on each candy bar. Pre-tax profits are $85 million annually.

What is your recommendation?

5

MINICASE SKA, Inc. manufactures roller blades and skateboards. Current financial data for these two products lines is ($millions): Sales Cost of goods sold Gross margin Operating expenses: Depreciation Taxes Interest Other Segment margin

Roller Blades $30.5 15.5 15.0

Skateboards 25.5 10.0 15.5

10.0 1.0 2.0 2.0 $0

8.0 1.0 2.0 1.0 $3.5

Depreciation is actually incurred by the segment, as is one half of “other expenses”.

Otherwise, expenses are allocated from the central office. Corporate-level income taxes are 34% federal, and 8% state (both products are sold in all 50 states).

Management is concerned above the lack of profit for roller blades.

A consultation with the firm’s accountants reveals that, except for depreciation, the above revenue and expenses are the same for tax purposes. Depreciation is approximately 1.5 times larger for tax purposes.

6

Because your major competitor is a publicly traded corporation, your accountants are able to access the following segmental and tax note data, respectively (in $millions): Sales Cost of goods sold Gross margin Operating expenses: Depreciation Taxes Interest Other Segment margin

Roller Blades 25.0 13.5 11.5

Skateboards 100.5 55.0 44.5

8.0 2.0 1.5 2.5 $<2.5>

20.0 12.0 2.0 4.0 6.5

The tax note reveals that the competitor, despite a $4 million accounting income, has a $10 million NOL carryforward for tax purposes. Moreover, this NOL is not expected to expire for five years.

In deciding whether to discontinue roller blades, you consider that the plant could be sold for a very small profit. The plant, located in a small city in the Southeast, pays $ 1 million in local taxes (property, licenses, and fees) and employs 5,000 local people.

Based on quantitative analysis (10% cost of capital, 45% overall income tax rate), provide a recommendation.

7

COMPREHENSIVE STRATEGY CASE: DATASERVE (PART 10) Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

8

DATASERVE (PART 10) Refer back to the original Dataserve case in Chapter 3. Assume the firm is a C corporation.

Jimmy and Roman have examined product-line information for the company, and they are concerned with sales to smaller firms. The data is ($thousands, 2002): Company

Big Firms

Small Firms

$200,000 435,213 635,213

$150,000 326,410 476,410

$50,000 108,803 158,803

72,536 281,081 150,000 5,900 32,541 107,000 3,250 5,750 100,000

58,089 140,541 112,500 2,950 24,406 53,500 1,625 2,875 50,000

14,507 140,540 37,500 2,950 8,135 53,500 1,625 2,875 50,000

758,057 (122,844)

446,486 29,924

311,571 <152,768>

(50,000)

(25,000)

<25,000>

(172,844) (60,495) (112,349)

4,924 1,723 3,201

<177,768> <62,219> <115,549>

Revenue: License Service Total Revenue Operating Expenses: Cost of revenues Research and development Sales and marketing Partners Life Insurance Premium Provision for Bad Debts Depreciation Expense Amortization of Start-up Costs Amortization of Organization Costs General and administrative Compensation - John Compensation - Roman Total operating expenses Operating income Other income (Expenses) Interest income Interest expense Interest Before income taxes Provision for income taxes Net Income

On further inquiry, they found out that many of the shared expenses were simply allocated evenly between the two types of firms.

Because of its apparent nonprofitability, they want some advice as to whether to stop serving the small firm market.

9

STRATEGIC BUSINESS TAX PLANNING Chapter 13 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

CONCEPT APPLICATIONS 1.

In the last few years, a number of large, publicly traded corporations have repurchased large amounts of their shares for cash. What are the tax/non-tax reasons for doing this?

Why weren’t these redemptions structured as tax free transactions?

2.

During the 1980s, many (if not most) major U.S. businesses undertook some sort of CPR. What role would income taxes have played in designing the CPRs?

3.

Consider the Rockwell spinoff, reported in the Tax Management in Action. Why would Rockwell not simply have sold off the automotive parts business?

4.

A large corporation is considering spinning off one of its business units into a separate corporation, owned primarily by its shareholders. As part of the transaction, the corporation is considering giving some dissident shareholders cash to buy out their interests. Using the SAVANT framework, what would you recommend?

2

PROBLEMS (Refer to the corresponding Concept Applications) 1.

The balance sheet of a large, publicly traded corporation is as follows ($millions) Debt: Accounts payable Bonds payable

Equity: Common stock Retained earnings

1.5 10.5 12.0

3.0 25.0 28.0 40.0

The stock is currently undervalued, trading at $1 per share (book value is $3 per share). Management currently owns 42% of the stock. It is considering a stock repurchase for cash, or by issuing bonds. The 10-year bonds would be in $1,000 amounts, paying 8%. The firm’s dividend history has been 30 per share. Quantify your analysis and make a recommendation to management, assuming a 10% cost of capital, and a 10-year investment horizon. How would your answer change if there were a net operating loss (NOL)?

2.

Suppose, on the advice of a management consulting company, a bank reengineers itself.

It shifts its delivery of consumer banking services to be more convenient. Instead of a number of local bank offices, it shut down many of them, and puts “local banks” in many shopping malls and grocery stores. These local banks are ATM machines, accompanied periodically by a bank representative. The consulting firm was paid $1 million, and the firm spent $2 million internally for marketing research. The bank closures would obviate $10 million per year in operating costs (wages, building leases, and other operating costs). The 2,000 ATMs would cost $10,000 each and have MARCS lives of five years.

The firm, in the 45% (combined) tax bracket, has a 10% cost of capital, and will borrow to finance the ATMs. Because of the novelty of the restructuring, management can only estimate the likelihood of its success: 50% that it will increase customer revenues by $4 million per year. What is your advice to management? Assume a 10% cost of capital, and a 10-year investment horizon.

3

Commented [h1]: Spell out MARCS

3.

Suppose a firm has a division with the following financial statistics ($millions): All Other Divisions (Including Parent) 150 75 75 20 55 10 20 25 12%

Sales Cost of goods sold Gross margin Operating expenses NIBIT Interest Taxes Net Income As % of assets

Automotive Division 100 50 50 40 10 5 2 3 2%

Management believes that the current stock is undervalued at five times earnings. It feels that either spinning off the division, or selling it outright, would boost the stock price. Management has two alternative plans: Plan 1 Parent Corp

Newly created subsidiary

Parent Co. stock

Sub stock

Parent shareholders

Plan 2 Sell assets to another firm for $20 million. The tax basis of the assets is $8 million. The firm’s cost of capital is 10%, and its overall tax rate is 50%. Provide a recommendation to management.

4

MINICASE Eunice, Inc. was a holding company for a number of firms in a number of industries. Recently, its stock has been underperforming, and management hired a consulting firm who recommended one of two possible strategies: financial or legal entity restructuring. In the former, $100 million of the firm’s high (10%) interest debt (due in eight years) would be called and replaced by either 8% convertible 10-year debt, or common stock, either with a market value of $100 million.

Under the organizational restructuring, the conglomerate would be split into two holding companies: Eunice-A and Eunice -B. The former would hold service-industry firms, the latter merchandising firms. The proposed reorganized conglomerates’ income statement would appear as follows ($millions):

Sales Cost of sales Gross margin Operating expenses NIBIT Interest Taxes NI ROA

Eunice - A $300 150 150 30 120 6 50 64 20%

Eunice-B $250 180 70 30 40 4 15 21 8%

Each holder of Eunice stock would receive one share each of Eunice A and Eunice B. The plan would have to be approved by shareholders. Some major institutional investors may want to receive cash instead, and might press for this option at the quarterly shareholders meeting.

Shareholders have historically received 90% of net income as dividends.

Which restructuring plan would you recommend to management? Would your answer change if the firm had a large net operating loss (NOL) carryforward?

5

COMPREHENSIVE STRATEGY CASES: DATASERVE (PART 11) and DOOLITTLE & BRADBURY Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

6

DATASERVE (PART 11) Refer to the Dataserve (Part 10) case.

After looking over the operating data for both small and large firms, John and Roman were split on what to do. Jimmy wanted to get out of the small client business entirely. He proposed selling off part of the business to a smaller, upstart computer network company. Roman wanted to keep the small firm practice, but felt that, with an initial public offering impending, the negative bottom line would hurt the stock price. He felt that there should be a split-up into two separate corporations, each owned equally by Jimmy and Roman, with only the large-client business eventually going public.

The following is relevant to their decision: ▪

They each own 3,000 shares of Dataserve’s $100 par value stock.

▪

One-fourth of the company’s assets and liabilities are related to the small client business (refer back to the balance sheet for the original Dataserve case, chapter 3).

▪

A small, startup firm is willing to buy the small-firm practice for 10-times its revenue. They would be willing to pay cash, but only want to purchase the assets, not stock.

▪

Under the split-up plan, two new companies would be formed: Dataserve-A and DataserveB. A, the large client firm would issue 2,250 shares of $100 par stock (split evenly between Jimmy and Roman). B would issue 750 shares of $100 par common.

▪

Under a split-up, they are also considering some financial restructuring. Most of the longterm debtholders (banks) would be given shares of A and B stock.

Make a recommendation from a SAVANT perspective.

7

COMPREHENSIVE STRATEGY CASE: DOLITTLE & BRADBURY BACKGROUND ON DOLITTLE & BRADBURY’S REORGANIZATION On January 9, 2001, Dolittle & Bradbury, a world wide marketer of information, software, and business decision-making services announced a reorganization which would split the 155-yearold company into three separate entities: the “new” Dolittle & Bradbury (D&B), Neural Corporation, and DW Swenson.

The D&B consists of Information Services, a leading provider of commercial and credit and business marketing information and receivables management services; Hardy’s Investor Service, a leading debt rating agency and a major publisher of financial information for investors; and J.Willaby, largest independent marketer of Yellow Pages in the United States. Neural Corporation has operating units which include IMS International, the leading global supplier of marketing information to the pharmaceutical and healthcare industries; Swenson Media Research, the leader in audience measurement for electronic media; Hefner Group (in which Neural owns a majority interest), the premier provider of advisory services to high-tech users, vendors, and suppliers. DW Swenson provides market research, information, and analysis for the consumer products and services industries.

The Board of Directors of D&B declared a special dividend on October 10, 2001 to affect the reorganization plan. Shareholders of record on October 21, 2001 received one share of Neural for each share of D&B stock held and one share of DW Swenson for every three shares of D&B stock. No fractional shares of DW Swenson were issued; rather, shareholders were paid cash for any such fractional shares.

By November 1, 2001, D&B completed its strategic restructuring into three separate, publicly held companies. “Regular way” trading for each of the independent companies began on November 4, 2001 on the New York Stock Exchange.

BUSINESS REASONS FOR DOLITTLE & BRADBURY REORGANIZATION According to William Goldman, chairman and CEO of Dolittle & Bradbury, the driving force behind the spin-off was to “enhance shareholder value by unlocking Dolittle & Bradbury’s substantial underlying franchise strengths.” The company believes that by separating these businesses, each will be able to tailor their strategies to the unique demands of their respective markets. Further, the separation will allow them to determine investments, capital structures, and policies that will strengthen their global capacities.

Looking at D&B today, it may be easier to understand why D&B is splitting up than to understand why these companies were ever put together. Understanding requires an historical perspective. As D&B grew and expanded over the years, the company’s competitive strategy was to attempt to achieve economies of scope and scale in its operations. The unifying factor was that all of D&B businesses gathered and processed large quantities of information, and thus, all required huge investments in information and communications technology. All of these divisions of D&B acquired, disseminated, improved, and sold business information; and therefore, all these divisions could share the huge technological investments. Over the years, management believed that each new corporate acquisition created new synergies, and yet none of these “synergies” proved long-lasting. Today, the cost of computing has fallen so dramatically that the need to share basic technology no longer exists. Thus, synergies that existed have 8

disappeared because D&B’s business have become so diverse that no single factor or any need unites them now. In fact, D&B’s headquarters did little in recent times to manage the different divisions before the split. It took a very hands-off approach precisely because its operations were so varied.

Today, the competitive edge in information services comes from speed and market focus. By splitting up, each of the three new companies will be able to focus on its own core vertical market and thus move into emerging growth areas. Each company will be able to formulate its own strategies for its own markets. This is important because the three new companies are very different positions and have very different needs for their future growth. The division of D&B into three parts will separate the company’s low-growth and high-growth businesses. For example, D&B has a number of mature and profitable businesses. Based on the profits of these businesses, D&B has a long history of declaring dividends that absorb as much as 70% of its free cash flow, and its shareholders expect the company’s cash to continue to flow to them.

However, Neural and DW Swenson both need to retain cash in order to expand and reinvest in their businesses: Neural intends to acquire other companies, and DW Swenson intends to invest in new services. In hindsight, it seems clear that D&B maintained its dividend rate at too high a level for too long a time, and the other operations suffered as a consequence. In fact, D&B increased its dividends to shareholders even in years when earnings dropped. Even though D&B’s reorganization will effectively reduce the dividend of the composite company, the restructuring will liberate the diverse businesses and allow them to pursue their own growth strategies.

A survey conducted within D&B indicated that increased competition in the rating industry and turmoil at Hardy’s were additional factors in the decision to split. However, D&B’s spokesman, Rod Hart, denied that either of these were legitimate reasons for the reorganization.

Rather, company officials maintained that managing the old D&B had become too difficult because the businesses were so diverse.

Historically, D&B catered to investors who sought constant and substantial dividend distributions (see following dividend payout graph). The three new companies will now cater to three different stock market tastes. The reorganization clarifies D&B from an investor’s perspective by grouping the businesses into three logical investment categories, each with distinct risk/reward profiles. For instance, D&B should re-emerge as a steady growth business with a high dividend payout, which should attract yield investors. Cognizant will retain the faster-growing marketing information businesses, which should attract growth funds.

Meanwhile, DW Swenson is being positioned as a turnaround play where no one should expect a dividend for at least the foreseeable future; this company’s stock is expected to appeal to aggressive investors. By splitting into three pieces, D&B hopes to achieve reverse synergy.

That is, it hopes that the sum of its parts will be greater than the whole by offering investors the unique investment opportunities they seek.

9

Dividends Per Share 3 2.5 2 1.5 1 0.5 0 1994

1996

1998

2000

Regulatory concerns in D&B’s spin-off were minimal. Each of the new companies will have to comply with the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act requires full disclosure of all information material to investment decisions regarding securities offered for sale to the public. This Act attempts to prevent fraud. Specifically, each of the three new companies must file with the Security and Exchange Commission: (1) a registration statement, (2) a prospectus, and (3) financial statements. The 1934 Act spells out ongoing financial and reporting requirements. D&B filed a Form 8-K in October of 2001; this form shows operating results restated to reflect the reorganization. In addition to domestic filing requirements, the three new companies also had to comply with international regulations, which proved to be a lengthy and time-consuming process.

FEDERAL INCOME TAX CONSEQUENCES OF THE DISTRIBUTION In addition to the business reasons for the reorganization, tax considerations also played an important role. For the spin-off to occur, it was imperative that the transaction receive tax-free treatment.

Commented [h2]: Please ensure the heading levels are correct in this section

COMPANY OUTLOOK AND FORECAST D&B

Together, D&B and Hardy’s comprise one of the most formidable business information and credit evaluation company in the world. D&B also benefits from the strong cash flow generated

by Willaby. By accelerating the development of products to meet emerging customer needs, tomorrow’s D&B is financially strong with outstanding franchises that generate solid, reliable growth, high margins, and significant cash flow. With healthy cash flow generation from its three core businesses, D&B will have ample resources to service debt, pay dividends, and 10

reinvest in growth, all while maintaining an investment grade rating. D&B expects a 4 to 6% growth in earnings, of which 55 to 60% will be distributed. For additional forecasting data, see Schedule 1.

Neural’s liquid balance sheet and strong cash flow provide excellent financial flexibility to enhance shareholder value. Its 2002 investment priorities include a major share repurchase program aimed at increasing the company’s stock price, which management believes is undervalued. It also plans to invest in its core businesses in order to sustain high-growth levels.

Neural will operate in enormously attractive information markets. Furthermore, its aggressive new product initiatives, expanding electronic distribution channels, and entry into new market segments via acquisitions are typical of growth oriented investors. Earnings growth of 17 to 20% is expected in 2002. For additional forecasting data, see Schedule 1.

DW Swenson expects to maximize its customer service, further integrate its businesses across the region, concentrate on operating more effectively, and to grow the bottom line. The company is focusing on the fast moving consumer package industry, recognizing both the strong growth potential for the business and the intensely competitive environment. Its efforts to streamline operations, enhance quality, reduce delivery time, and provide superior service to its clients are reinforcing DW Swenson’s position as a global leader in market research. DW Swenson has the potential to yield significant shareholder value near-term and to provide a solid long-term return. Earnings in 2002 are expected to rise by a factor of between 2.5 and 3.0% with no dividend payout. For additional forecasting data, see Schedule 1.

FINANCIAL PERFORMANCE ANALYSIS As mentioned earlier, it remains to be seen whether each separate entity will become more profitable as a result of the spin-off. Nonetheless, a comparison of fourth quarter results for 2000 and 2001 provides, at the very least, a starting point for future and ongoing analysis. This section highlights the financial performance of D&B, Neural, and DW Swenson for the threemonth period ended December 31, 2001 (post spin-off), as compared to the same period in 2000 (pre sign-off).

The new D&B released its 2001 fourth quarter results in February on both an “adjusted” and “reported” basis. Adjusted basis resulted exclude the one-time transaction costs associated with the reorganization, other nonrecurring items, and the results of divested businesses. Adjusted results also reflect D&B’s expected overhead and interest run-rate expenses and its new underlying tax rate of 34%.

Adjusted fourth quarter operating income rose approximately 7% from $222.3 million in 2000 to $238.6 million in 2001. Results of operating on a reported basis showed that the company suffered a $115.9 million fourth quarter loss in 2001, as compared to a $105.7 million fourth quarter loss in 2000. However, on an adjusted basis, net income amounted to $144.8 million, or $.86 per share, and $133.4 million, or $.79 per share in 2001 and 2000 respectively, representing an 8.8% increase.

Fourth Quarter Results Operating Income Net Income Earnings per share (EPS)

2001 $238.6M $144.8M $0.86

2000 $222.3M $133.4M $0.79

% Change 7.3 8.8 8.8

11

Neural posted operating income figures of $142.1 million in the fourth quarter of 2001 and $95.4 million in 2000, including $90.1 million of nonrecurring charges. Net income for the quarter grew 26% from $77.2 million, or $.46 per share, to $79.5 million, or $.58 per share including the $.02 per share post spin-off one-time net gain.

Fourth Quarter Results Operating Income Net Income EPS

2001 $142.1M $79.5M $0.58

2000 $95.4M $77.2M $0.46

% Change 46.7 3 26

DW Swenson reported a significant jump in fourth quarter operating revenue from 2000 to 2001. The company’s net income for the last quarter in 2001 was $11.4 million, or $.20 per share, compared to a net loss of $19.7 million, or $.35 per share in the fourth quarter of 2000, excluding the impact of a $152.2 million nonrecurring charge. Including the charge, the company’s net loss for the quarter was $161 million, or $2.85 per share.

Fourth Quarter Results Operating Income Net Income EPS

2001 $20.7M $11.4M $0.20

2000 $3.6M $(19.7)M ($0.35)

% Change 475 158 158

Based on the unaudited data provided above, each business improved fourth quarter performance between 2000 and 2001. Annual results of operations also reflected across-theboard increases for all three businesses in 2001. Unfortunately, it is difficult to isolate or directly link improved financial performance or enhanced shareholder value to the reorganization.

Nevertheless, tracking the future results of operations and these companies’ stock market performance can provide some indication of the level of success achieved as a result of the spinoff.

STOCK MARKET ANALYSIS Wall Street greeted Dolittle & Bradbury’s spin-off announcement with a boost in the company’s stock price, which rose by $1.50 to $65 per share. The increased share price impacted D&B’s company value, which climbed to $11 billion. It appeared that after 10 years of consistent stock market performance (or underperformance), investors were relieved to see signs of change.

Stock prices were relatively stable throughout the months leading up to the spin-off.

Immediately prior to the distribution of Neural and DW Swenson shares, the stock price fell to $58 per share. This drop in price likely stemmed from shareholders’ concerns over possible declines in dividend distribution amounts, as well as their uncertainty regarding the three companies’ future performance levels.

When Neural and DW Swenson began trading on the New York Stock Exchange, new D&B’s share price dropped drastically to $22, reflecting its divestiture in those businesses and shareholders rights in Neural and DW Swenson stock. Neural made its market debut at $33 per share, while DW Swenson began trading at $15.40. These prices demonstrate the perceived value of each of these separate companies, and when combined, are roughly equal to D&B’s share prior to the spin-off announcement.

12

The following provides the stock market performance of D&B (subsequent to the reorganization), Neural, and DW Swenson on the New York Stock Exchange. Please refer to the attached Graphs for further detail.

Commented [h3]: Where are the graphs for reference

D&B

D&B’s stock price has remained relatively flat since the spin-off. Prices have not dropped below $21 per share and have not exceeded $29 per share. Its stock was trading $24.50 at the close of business on April 4, 2002. Compared to the other two companies, D&B has maintained the highest level of share volume following the initial trading in November. D&B indexed price performance was in line with Standard & Poor’s 500 (S&P 500) companies throughout most of July 2001. From late July to late October, D&B’s performance lagged somewhat behind the S&P index. This gap widened during the time immediately preceding the spun-off companies’ arrival on the market. However, its recent performance has been more in line with S&P 500, which is reassuring.

Neural Neural showed sharp price increases during the month of November and into early December.

Since that time, the price has fluctuated between $31 and $35 per share. However, late March and early April have been unkind to the company; its stock closed at $28.50 on April 4, 2002.

The company’s volume of trading was substantial in November but tapered off thereafter.

Nonetheless, it experienced more activity than DW Swenson. During the first half of November, Neural’s indexed price performance fell below the S&P 500. However, its performance topped the S&P 500 during the second half of November and early December. Since the end of December the disparity between the two has been slowly increasing.

DW Swenson DW Swenson’s stock price increased steadily throughout November and declined just as steadily during the first half of December, before reaching a low of $14.50 on December 16, 2001.

However, the price picked up again through the end of January. Since then, it has declined, and it posted a 2002 low of $14.25 on April 4. DW Swenson experienced significant share volume during the month of November but very little in the ensuing months. DW Swenson has experienced the largest disparity between its indexed price performance and that of the S&P 500, as well as the smallest fluctuation therein.

Although all three companies have experienced recent declines in their respective stock market prices and trading volumes, there appears to be no reason for alarm yet. The effect of these price contractions is small when all prices for the past five months are taken into consideration. Of some concern, however, is that each company’s indexed price performance has generally been below the Standard & Poor’s 500 companies. Nonetheless, despite fluctuating stock prices and sub-par indexed price performance, D&B, Neural and DW Swenson look to be well poised for future growth and profitability. How long it will take to fully recognize each company’s anticipated shareholder value enhancement and improved company performance resulting from the spin-off is unknown. In the interim, the company’s management may have a difficult time proving to its skeptical stockholders that its stock is in fact undervalued.

Commented [h4]: Why is this called “Required”?

Required

13

1. What were the tax consequences to all parties, assuming there was a valid tax free reorganization?

2. How would your answer to question 1 change if the IRS had classified it as a taxable transaction?

3. How would the entities’ financial health be if it were taxable? Using the SAVANT framework, would the transaction still be worth doing?

SCHEDULE 1 4-Apr-02

DW Swenson

Neural

D&B

Stock Value Ratios Close 52 Week High $ 52 Week Low $ Price/Earnings Earnings Yield Dividend Yield

14.25 20.13 14.5 50.89 1.96 N/A

28.5 38 29.63 20.5 4.88 0.11

24.5 27.94 20.88 17.01 5.88 5.63

S&P Ranking EPS(TTM) $

NR 0.28

NR 1.26

A1.18

1.18%

13.67%

6.34%

0.19 -0.09 0.21 0.51 0.74

0.55 0.29 0.37 1.75 2.08

0.19 0.29 1.79 1.94

82.14% 164.29%

25.90% 49.64%

24.31% 34.72%

119.16 22.27 52.08 7.8 N/A N/A

28.91 22.27 16.63 7.8 N/A N/A

-54.42 22.27 1.19 7.8 4.8 7.1

Efficiency Measures After Tax Margin Earnings Per Share Estimate Analysis - Forecasts Mar-97 Jun-97 Sep-97 Fiscal Year Total 1997 Fiscal Year Total 1998 Forecast EPS Growth 1997 Forecast EPS Growth 1998 Company vs Industry EPS Growth % S&P Indus EPS Growth % Revenue Growth% S&P Indus. Revenue Growth % Dividend Growth % S&P Dividend Growth %

14

STRATEGIC BUSINESS TAX PLANNING Chapter 14 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

Commented [h1]: Problems and Minicases?

CONCEPT APPLICATION You are CEO for a major metal fabrication company. Earnings growth in your industry is expected to remain stagnant for a number of years, so you are contemplating acquiring another firm. Your financial analysts have identified two firms which have high earnings and appear to be underpriced: a biotech firm, and one of your suppliers, an aluminum company. You have learned that the former has a significant net operating loss (NOL) carryover, which appears not to have been impounded into the purchase price. Comment on both from a SAVANT perspective.

2

COMPREHENSIVE STRATEGY CASES: DATASERVE (PART 12) and FIRST WEST BANK Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

3

DATASERVE (PART 12) Refer to the original Dataserve case in Chapter 3. Assume it is a C corporation.

Although Jimmy and Roman foresaw internal growth as the path to fulfilling their strategic plan, the purchase opportunity before them seemed too good to pass up. The owner of Cybernet, Inc., the largest network/software service company in the local healthcare industry, was ready to retire. He was willing to sell out to Dataserve; it was simply a matter of negotiating the terms.

The income statement and balance sheet were: Income Statement Revenue - License Service Total Expenses Cost of revenues R&D Sales & marketing Depreciation S, G&A Salaries - owner others Interest Taxes Net Income

$220,000 310,000 530,000 20,000 30,000 10,000 120,000 40,000 150,000 150,000 20,000 1,000 <11,000>

4

Balance Sheet Assets Current assets: Cash and short-term investments Account receivable Allowance for bad debts Total current assets

300,000 210,000 <15,000> 495,500

Intangible assets, net Property, plants, and equipment, net Total Assets

400,000 350,000 1,245,500

Current Liabilities: Accounts Payable Customer advances and unearned revenue Short-term Debt Total Current Liabilities Long-term Debt Total Liabilities Equity: Paid-in-Capital Retained Earnings Total Equity Total Liability and Equity

50,000 250,000 10,000 310,000 350,000 660,000

200,000 385,000 585,000 1,140,000

The firm was an S corporation. Jimmy and Roman felt that if R&D were doubled, $200,000 of new equipment were bought, the firm could triple its revenues and yield large profits.

There were three proposed ways to structure the deal: 1. A cash buyout for $700,000. This could be done by either buying the assets (and assuming $350,000 of debt) or buying the stock (from the owner); 2. A stock for stock swap. Dataserve would issue an additional 4,000 shares to Cybernet’s owner, in exchange for all Cybernet stock; and 3. Issue 1,000 shares of Dataserve voting common, plus 2,000 shares of Dataserve 10% cumulative preferred, in return for the stock.

Jimmy and Roman felt that the following should also be taken into account: that Dataserve wanted to go public in the next few years; that any bank borrowing, at 10%, could not result in more than a 100% increase in their current debt: equity ratio (or the existing debt would be called); and that if they failed to reach an agreement, Codewise, Inc. (the leading local manufacturer-client software company) would have enough cash to buy Cybernet.

5

FIRST WEST BANK Industry Strategic Issues There are structural changes occurring in the banking industry that will make the already tight environment even more challenging in the years ahead. Specifically, revenue growth is likely to become even more of a challenge as banks exhaust their excess liquidity and as the historically high deposit spread shrinks. In addition, credit costs are rising.

The appropriate competitive response will focus on continual improvements in efficiency, effective capital management, and the identification and concentration of resources on new niche opportunities to establish competitive advantages over competitors. Efficiency gains can be accomplished through internal actions, but are more likely to occur through mergers and acquisitions. Capital management encompasses not only dividends and stock buyback programs but also the efficient use of capital. The pursuit of niche strategies are meant to generate high returns on invested capital and attract new sources of capital while expanding one’s customer base.

A drive for efficiency in their slow growth business and the desire to be in the best position to invest in new technology have spurred hundreds of U.S. bank mergers. The largest of these mergers is the First West and Interregional Merger.

First West’s Business First West was founded in 1852 and is the eighth largest bank in the United States with assets of $108 billion. It is the second largest bank in California and has extensive operations in 12 other western states. The bank has over 1,150 staffed service outlets in 13 western states, 2,400 automated teller machines, and a 24-hour banking telephone service. In addition to serving as banker to more than 3.5 million households in California, First West provides a full range of banking services to commercial, agribusiness, real estate, and small business customers.

First West’s $11.6 billion takeover of Interregional was the largest hostile bank deal ever and the largest hostile takeover in any industry funded entirely through an exchange of common equity.

First West’s Acquisition of Interregional The major component’s of management’s takeover plan for the combined company include the realignment of Interregional’s businesses to reflect First West’s structure, consolidation of retail branches and administrative facilities, and reduction in staffing levels. The resulting business combination was projected to save $800 million from Interregional’s expense base. Although First West was focusing on cost savings there is still a human cost involved. First West’s plans called for an estimated 9,000 jobs lost and the closure of over 350 of Interregional’s 405 branches.

The saga began on September 7, 2000 as First West CEO Paul Hayes approached Interregional CEO David Stuart about the possibility of a merger. Interregional had already been considering a variety of strategic options, including mergers with several other banks. Stuart rejected Hayes’ offer until Interregional reviewed other potential mergers already on the table.

Stuart felt that First West’s retail distribution strategy was too different from that of Interregional. Stuart felt that a combination of such different strategies was risky and feared that 6

First West would dismantle Interregional in the same manner in which they dismembered Crocker Bank 10 years prior.

Hayes was prepared to wage a hostile deal; in fact Hayes had already recommended this course of action to his own board before presenting the offer to Interregional. Hayes was confident that no one could offer Interregional shareholders as much economic value as First West. Also, since First West was the only acquirer in the same markets, they could bid higher since they would be able to cut more costs through the elimination of redundant operations. First West had tremendous loyalty from Wall Street analysts and institutional stockholders.

Additionally, its stock was trading at nearly three times its book value which gave it a strong currency in which to complete the deal.

Initially, there was a possibility that this deal would not be completed and instead that First Bank Systems (FBS) would acquire Interregional. Ultimately though mergers are about numbers and First West was able to put up better numbers. Thanks to its position as an in-market competitor, First West could cut enough redundant operations to eliminate $800 million from Interregional’s expense base versus FBS’ aggressively estimated $500 million in cost savings (savings that Wall Street never fully embraced as achievable). Additionally, Interregional’s own financial advisors stated in their fairness opinion that the original First West proposal at an exchange ratio of 0.625 (the final ratio was 0.66) was fair from a financial point of view.

Finally, FBS received an adverse ruling from the Securities and Exchange Commission (SEC) regarding the repurchase and subsequent issuance of their own stock to be used in the acquisition. FBS would be forced to resell the 1.5 million “tainted” shares of stock recently repurchased, and would be precluded from repurchasing any additional stock for two years.

FBS’ offer was ultimately withdrawn, and First West paid them a $200 million termination fee in exchange for the withdrawal and cessation of all litigation. On April 1, 2001 First West completed the acquisition of Interregional for $11.6 billion in stock.

Strategies Issues for First West Revenue Challenge

First West’s revenues have benefited from robust loan growth over the past two years through the redeployment of excess liquidity raised from the sale of low yielding assets and investment securities. The build-up of investment securities took place during the early 1990s when First West took advantage of an unusually steep yield curve. Furthermore, First West’s excess liquidity has meant that there has been no real need to compete aggressively for consumer funds.

As such, deposit rates have remained low, relative to market rates, and their core deposits have grown much more slowly than have loans. This trend is likely to continue in the short term, but strategically First West must deploy its capital and have a large capital base to maximize revenues in a lower margin environment. This factor drove the acquisition of Interregional.

Credit Costs

Industry wide, credit costs have been below normal for the past years due to a relatively benign economic environment, prior recognition of usually aggressive loan write-offs in the early 1990s, and a deliberate policy of reducing loan-loss reserves. First West is behind this curve, but will benefit as California continues to make progress in its recovery from the recent severe recession.

Credit costs may continue to decline for the years ahead as a great portion of First West’s business is in California. Basic industry grew at satisfactory rates while construction and defense sectors began to recover. All areas are being helped by lower overall interest rates, but 7

delinquencies on loans are trending higher. Being squeezed between the revenue challenge and rising credit costs, First West must work to continually cut costs either through internal efforts or through mergers (as was the case with the Interregional merger). At the same time, enormous opportunities exist for First West to deploy capital through niche opportunities to establish a material advantage over their competitors.

Cost Management: From the Inside First West has cost opportunities that are functions of advances in computer and telecommunications technology. Their faster and cheaper systems are achieved through economies of scale. They not only allow existing processes to be done faster and cheaper, but also permit process redesign which can lower cost and increase service quality. Examples of this are First West’s On-Line Financial Services and Supermarket Banking Centers. The Supermarket Banking Centers are small branch offices with an ATM and typically one or two employee who provide substantially all consumer services. These centers reduce overhead, and maximize revenues per square foot. First West acquired Interregional to take advantage of the opportunity to move to common systems in their multi state operations. This feature reduces the enormous redundancy in the wide spread operations.

Acquisition-Based Cost Cutting In today’s environment, First West found itself sufficiently confident of its ability to cut costs and was able to pay top dollar, $11.6 billion, for Interregional while still adding value to their shareholders. In fact even with a geographical overlap, FBS believed that it could cut $500 million from Interregional’s cost structure without any associated loss of revenue through the utilization of their internal cost management systems. First West estimated that they could reduce costs by a net $800 million due to redundancies, and cost savings associated with such.

Capital Management As a broad statement, many banks today are generating capital at a more rapid rate than they can profitably or safely reinvest in their existing business. As a result, there is a wave of shock repurchases taking place.

First West’s acquisition of Interregional and share repurchase program is aimed at maximizing shareholder value. However, First West is working against stock buyback authorization equivalent to 10% of outstanding shares at the time of the announcement.

Effective capital management is First West’s key to keeping bank management focused on creating shareholder value.

Nice Opportunities A successful offensive strategy is to find and exploit nice opportunities. This will create new core competencies, establish additional barriers to entry, and establish first mover advantages in highly profitable areas. The “me-too” set of products and services is not likely to add much value to customers or shareholders. First West has implemented several new niche strategies such as the Supermarket Banking Centers, On-Line Banking, and database marketing techniques similar to the credit card issuers. These new services, combined with the client base of both First West and Interregional, will give First West additional relative power over their customers, suppliers, and more importantly their competitors.

8

Porter Framework (See Exhibit1) Barriers to Entry/Exit

First West has established relative power and large barriers to entry with an integrated and highly efficient branch operation combined with the implementation of the Supermarket Banking Centers and their ATM network. Regulatory issues on the merger were put to rest on January 22, 2001 when the Federal Reserve and the SEC made an adverse ruling for FBS and gave approval for the merger with First West. This approval gave First West relative power from a regulatory standpoint. In addition, First West has enormous brand equity as the eleventh largest bank in the United States before the merger, and eighth largest after the merger.

Customers

Customers have relative power over the entire industry as they could easily substitute another bank due to the great homogeneity amongst the largest bank. First West attempts to break this power, or at least to have relatively more power over its competitors, through the convenience it offers. Of First West’s 1,150 branches, 70% are Supermarket Banking Centers, thus giving customers convenience and accessibility over their competitors. The strategy is to minimize costs and maximize revenues as discussed above.

Substitutes

While First West competes with local banks, its main strategic concerns are with new technologies and competitors. These new competitors are stock brokerage firms that are handling more client assets each year, and on-line services from such diverse nonbanking companies as Intuit and Microsoft. First West has responded through their 24-hour Phone Service Centers, On-Line Financial Services, and Stagecoach and Overland Express families of mutual funds. These along with the barriers to entry are maintaining First West’s relative power over substitutes.

Suppliers

Suppliers for First West are providers of capital which range from Wall Street (also potential competitors), depositors, the government for mortgage lending and supermarkets for space and customers. Due to their financial strength and outstanding financial performance, First West has no difficulty in raising capital either internally or externally. Additionally, First West’s excess liquidity has meant that there has been no real need to compete aggressively for consumer funds.

Their deposit rates have remained low, relative to market rates, and their core deposits have grown much slowly than have loans. This relative power is likely to continue.

Financing and Stock Market Implications The merger between Interregional and First West was the largest hostile takeover in any industry funded solely through an exchange of common equity. Unlike an all-cash offer, whose value remains steady throughout the life of the bid, an equity offer can rise and fall in value in connection with the trading value of the stock itself.

The merger, valued at $11.6 billion, began as a hostile takeover bid launched by San Francisco-based First West in September of 2000 and ended when Interregional, based in Los Angeles, agreed to be acquired in January of 2001, after FBS withdrew a competing merger offer. The stock market reacted dramatically toward this merger war.

9

The first act in the First West takeover began on September 7, 2000 when the CEO of Interregional discussed the possibility of a merger between the two companies. No agreement was reached at that point. On October 18, 2000, Interregional, and shortly thereafter First West publicly announced that First West had made a proposal (the “Original Proposal) to Interregional for a tax-free merger in which First West stockholders would receive 0.625 of a share of First West common stock for each share of Interregional stock. The market reacted favorably to the announcement and the investors showed their enthusiasm by driving both stocks to record highs.

First West common stock closed on that date at $229 per share having increased $15.375 per share. This was an increase of 7.2% from its closing price the day before. At the same time, Interregional common stock soared from 34¾ to 140¾. Based on that market price, the Original Proposal represented a $37.13 per share, or 35% premium to the closing price of the Interregional shares on the preceding day.

On November 5, 2000 FBS initiated and entered into a competing, yet friendly, formal merger agreement with Interregional, in which each share of Interregional would be converted into the right to receive 2.60 shares of FBS common stock. Such a merger produced value (at the 2.60 exchange ratio) of $132.28 per share. In comparison, the First West proposal produced a value (at the 0.65 exchange ratio) of $137.96 per share, or $5.68 per share higher. Given the difference in stock value, favorable response to the First West bid was expected from the stock market since stock prices are key in valuing the respective offers.

By the third week of November, it was apparent that First West was gaining the upper hand.

Strong investor support of its bid was evident from the way its stock had steadily climbed on the market particularly after November 13, 2000 when nudged its offered exchange ratio up to 0.66.

A sizable gap existed between the two offers: First West’s bid was worth about $142 a share, while FBS’ was approximately $135 a share. Not surprisingly, First West stock rose by several dollars in December and FBS stock slipped as time went by. Wall Street analysts said that the $13-per-share difference between the First West and FBS offers was rough, if not impossible, for FBS to close.

The gap reached its peak in January of 2001 when a SEC ruling further helped First West.

First West’s plan to buy back stock was not affected by the SEC ruling because it had chosen to use a different accounting treatment than FBS in regards to the merger. At that point, First West was offering $144.69 of its stock for every Interregional share while the FBS bid was worth $126.10 a share. Merger experts said that the $18.60-per-share gap between the value of the two bids and the SEC ruling increased the pressure on Interregional’s board to rethink the deal with FBS, and to consider the First West’s offer instead. Apparently stock traders believed that the First West bid would prevail because Interregional shares closed on January 19, 2001 at $138.875, up $3.325, far closer to the First West price.

The ware finally ended on January 24, 2001 when First West and Interregional announced that they had signed a definitive agreement under which First West would acquire Interregional in a stock transaction value at approximately $11.6 billion. Under the agreement, Interregional shareholders were to receive about 0.667 of First West common stock for each share of Interregional stock. The exchange ratio represented a price of $152.33 for each share of Interregional stock.

First West’s ultimate bid, which made the merger the most highly value in U.S. banking history, prevailed in part because of its aggressive cost-cutting goals. First West plans to close 10

350, or 81%, of Interregional branches in California. It also plans to reduce Interregional workforce by 9,000 or nearly 30% of bank’s total staff. Furthermore, First West was widely expected to aggressively consolidate Interregional institutional trust business and its other investment lines, given First West established strength in investment management.

Another reason for prevailing in the merger was that First West boosted profits an impressive 35% in the last quarter of 2000 and was earning an almost unheard of 2% return on assets and 30% return on equity. First West had done this in part by buying back millions of shares of stock and taking itself out of less profitable business ventures. The increase in First West’s return on equity boosted the confidence in investors, and in turn the stock prices the merger fight with FBS. The fluctuation in stock price during the merger negotiations for both First West and Interregional are reflected in the following chart. Also included are the dividends paid during that time.

First West Market Prices and Dividend

Interegional Stock Price and Dividends

Quarter 1999

High

Low

Dividend

Quarter 1999

High

Low

Dividend

First Second Third Fourth

147/12 159 1/2 160 3/8 149 5/8

127/58 136 5/8 145 1/8 141

$1.00 $1.00 $1.00 $1.00

First Second Third Fourth

78 3/4 83 7/8 83 1/2 81 3/8

63 1/4 72 1/2 72 3/4 67

$ 0.50 $ 0.75 $ 0.75 $ 0.75

82 1/8 88 1/4 103 141

68 5/8 75 1/8 79 3/4 100 3/4

$ 0.75 $ 0.75 $ 0.80 $ 0.80

154 1/2

130

2000 First Second Third Fourth

2000 160/58 185 7/8 189 229

143 3/8 157 177 3/4 190

$1.15 $1.15 $1.15 $1.15

2001 Jan-Feb

First Second Third Fourth 2001

235 3/4

208 1/8

$1.30

Jan-Feb

-

Financial Accounting Implications There are two basic accounting methods used for business combinations: (1) pooling of interest method and (2) purchase method. The purchase method is usually less preferred than the pooling method because goodwill is created and greater depreciation and amortization charges are reflected in future income statements. As such, future earnings per share are lower under the purchase method. In order to use the pooling of interest method, 12 specific conditions must be met. If any one of these conditions are not met, the purchase method must be used.

The theory underlying pooling of interests accounting is that a sale and purchase of business have not occurred. Two companies simply pool their financial resources and managerial talents such that the owners of each separate business are now the owners of an enlarged business. The fusion of equity interests occur only if the target company’s shareholders receive common stock 11

of the acquiring company as consideration for their business. Under the pooling method, the recorded assets and liabilities of the separate companies are carried forward to the combined corporation as their historically recorded amounts. Goodwill is never created and future income statements of the combined business never include goodwill amortization expense.

FBS planned to account for its proposed acquisition as a pooling of interest. There was a significant question as to whether the FBS transaction would qualify for pooling of interests accounting treatment in light of both the share repurchase program announced by FBS in connection with the Interregional merger agreement, and the number of tainted Interregional shares. Although FBS was approved by the SEC to use the pooling method, the SEC rejected the proposed accounting treatment of the share buy-back scheme that was an important part of FBS’ merger plan.

First West, however, accounted for the acquisition of Interregional common stock using the purchase method of accounting. The underlying concept of the purchase method accounting is that one entity has purchased the business of another entity. The acquiring company records at its cost the assets or the common stock acquired. The cost is based essentially on the value of the consideration given. It includes the fair value of the consideration given, the direct cost incurred in connection with the acquisition (excluding costs of registering with the SEC any securities given as consideration), and the fair value of any contingent consideration that is given subsequent to the acquisition date. Goodwill exists when the purchase price is above the current value of the acquired business’ net assets. Goodwill is reported in the financial statements as an asset of the acquiring company and must be amortized over a period not to exceed 40 years.

Since the merger was accounted for as a purchase, assets and liabilities of Interregional were adjusted to their estimated fair value and combined with the recorded book values of the assets and liabilities of First West. The purchase price was based on exchanging two-thirds of a share of First West common stock for each outstanding share of Interregional common stock at the closing price per share of First West common stock on January 19, 2001. The closing price was $217.25 and the exchange ratio presented a price of $152.33 for each share of Interregional’s common stock. The merger cost First West approximately $11.6 billion in stock. Shares issuable upon the exercise of Interregional’s stock options were not included in the number of outstanding shares of Interregional common stock on the assumption that all options would become equivalent options to purchase Interregional common stock. In addition to the total market value of the First West common stock to be issued, the total purchase price professional fees; printing and mailing costs; and other miscellaneous expenses.

It was estimated that about $700 million of costs related to premises, severance and other restructuring charges would be incurred in connection with the merger. Of this amount, approximately $400 million of costs related to Interregional’ premises, employees and operations, and affected the amount of goodwill involved in the merger. The remaining costs of approximately $300 million related to First West’ premises, employees, and operations as well as all costs relating to systems conversions and other indirect integration costs. There were to be expensed, either upon consummation of the merger or as incurred.

Goodwill due to the merger is to be amortized on a straight-line basis over 25 years.

Identifiable intangibles due to the merger are to be amortized on an accelerated basis.

Earnings per Share Considerations 12

The addition of Interregional’s $58 billion in assets was expected to have accelerating effects on First trust’s future profitability. However, First Trust’s profit was in fact hurt by the acquisition costs. Earnings per share dropped from $20.37 in 2000 to $12.21 in 2001. This decrease was mainly due to the expense of the merger. In addition, net income was reduced by the amortization of goodwill. Although the goodwill charge decreased per income, First Trust was free to buy back as much stock as it wanted to as a way of increasing its reported earnings per share through a reduction in the number of shares in circulation.

Conclusion The merger between First West and Interregional was the largest U.S. bank merger to date. It is the largest merger in any industry to be funded solely through an exchange of common equity.

First West was able to prevail over other suitors in part due to its aggressive cost-cutting goals.

Despite the fact that the merger meant the loss of jobs for many employees, and the closure of numerous branches, investors responded positively to the high bid. Whether the merger will result in greater profits and higher returns for shareholders remains to be seen in the years to come.

Required 1. Comment on each important transaction/event from a SAVANT perspective.

2. What were the tax implications to all parties involved?

3. If this had been a taxable acquisition, how would your answer to question 1 have changed?

4. If it had been a taxable acquisition, would it still have been worth doing (use the SAVANT framework).

13

EXHIBIT 1

Analysis of the Industry Structure (Porter Framework)

Barrier to Entry/Exit * Distribution - High * Regulations - High * Intangible Barriers - High * Customer * Brand Equity

Suppliers * Wall Street * Deposits * Individuals * Corporations * Government National Mortgage Association * Supermarkets * ATM Networks

Industry * First West * Chase * Bank of America * Interegional

Customers * Individuals * Corporations * Agricultural * Real Estate Mortgages * Credit Card Processing * Community Redevelopment

Substitutions * Credit Unions, Local banks * On-Line Banks (Intuit, Microsoft) * Stock Brokerage Accounts * Stock and Bonds * Money Market * AP I, II, III funds

Indicates Direction of Relative Power

14

STRATEGIC BUSINESS TAX PLANNING Chapter 15 Problems & Cases

Copyright © John Karayan & Charles Swenson, 2006 All Rights Reserved.

No part of this publication may be reproduced, stored in any retrieval system, or transmitted, in any form or any means, electronic, mechanical, photocopying, printing, recording, or otherwise, without the prior express written permission of the publisher. Printed in the United States.

Commented [h1]: Problems and Minicases?

CONCEPT APPLICATION As CFO of an agricultural equipment corporation, you have been asked by management to suggest a way to start a new experimental product. The new product is an electric/solar cell powered tractor. A significant amount of startup expenses, especially R&D, will ensure tax losses for at least five years. You are considering forming a wholly owned subsidiary, or forming a joint venture as a partnership or limited liability company (LLC), for the new product.

Prepare an analysis to support your presentation to the firm’s Board of Directors on this project.

2

COMPREHENSIVE STRATEGY CASES: DATASERVE (PART 13) and HANSEN & HANSEN Note to students: The philosophy behind the cases is that you identify important issues, using the SAVANT framework. No one expects you to get an exactly right answer. If, in doing your analyses, you think you need some additional information, make any reasonable assumptions you think necessary, noting in your answers what these assumptions are.

3

DATASERVE (PART 13) Refer to the original Dataserve case in Chapter 3. Assume it is a C corporation.

After only one year of operation, Jimmy decided he wanted to cash out and become a fulltime business school graduate student. Roman and Jimmy weighed the following alternatives: ▪

Cash, for redemption of his shares, in the amount of half the company’s retained earnings.

▪

Sale of the entire firm to another software firm for the amount of Dataserve’s retained earnings; or

▪

Exchange of Jimmy’s common for 10% preferred.

Analyze each from a SAVANT perspective.

4

HANSEN & HANSEN Hansen & Hansen, a large pharmaceutical corporation, wanted to acquire Burk, Inc. The purpose was to acquire its operating assets, and in particular, its patents (intangibles). It was going to pay $7 billion in cash, which was financed by newly issued 12% debt, payable in 20 years. The purchase price was to be used to buy, in a tender offer, the firm’s 1.5 billion shares.

After the acquisition, the corporation would be liquidated, with all assets (except property, plant and equipment, and intangibles) sold, and liabilities paid off. Revenues could be enhanced, to pay for the purchase, by dismissing all employees, and raising prices on the patented medicines by 50%.

The firm has not considered tax implications, and would like some advice.

5

Consolidated Balance Sheet For the Year Ended Dec. 31, 2004 (In $Millions) Assets Current Assets: Cash and cash equivalents Marketable securities at cost Accounts receivable trade, less allowances Inventories Deferred taxes on income Prepaid expenses and other receivables Total Current Assets Marketable securities, non-current Property, plant and equipment, net Intangible assets, net Deferred taxes on income Other assets Total Assets Liabilities and Shareowners' Equity Current Liabilities Loans and notes payable Accounts payable Accrued liabilities Accrued salaries, wages and commissions Taxes on income Total current liabilities

Book Value

$1,006 63 1,626 1,249 356 387

176 2,826 1,554 144 622 -

436 872 1,005 161 119 $2,592

Shareowners' Equity Preferred stock Common stock Note receivable from employee stock ownership plan Cumulative currency translation adjustments Retained earnings

768 (29) (61) 5,506 6,184

Total Liabilities and Shareholders' Equity

190 2,000 5,000

$10,005

705 85 54 1,151

Total Shareowners' Equity

1,006 80 1626 1,000 -

$4,685

Long term debt Deferred tax liability Certificates of extra compensation Other liabilities

Less common stock held in treasury, at cost

FMV

766 5,418 $10,005

6

7

Burk, Inc. Consolidated Statement of Earnings For the Year Ended Dec. 31, 2004 (In $Millions) Sales to customers Cost of product sold Selling, marketing and administrative expenses Research expense Interest expense Interest expense, net of portion capitalized Other expense, net Earnings before provision for taxes on income Provision for taxes on income

$10,810 $3,509 4,197 953 (70) 63 142 8,794 $2,017 573

Net earnings

1,444

Net earnings per share

$1.09

8