Net Operating Losses And Deferred Taxes

Question 1

How do you take into account NOLs in an M&A deal?

Answer 1

Allowable annual usage = equity purchase price x highest long term tax-exempt rate of past 3 months
- so if EPP 1 bil, highest adjusted long-term rate was 5% = £50 million of NOLs each year
- if seller has 250 mil of NOLs, combined company could use 50Mil for 5 years to offset taxable income

Question 2

Why do DTLs and DTAs get created in M&A deals?

Answer 2

When you write up or down assets.
Write up = DTL
Write down = DTA
You write down and write up assets because their books values (on BS) often differ substantially from their fair market values.
- an asset write-up creates a DTL because you’ll have a higher depreciation expense on the new asset, which means you save on taxes in the short term, but pay back - so a liability
- opposite applies for an asset write down

Question 3

How do DTLs and DTAs affect the Balance Sheet Adjustments in an M&A deal?

• buying a company for $1 billion with 50% cash and 50% debt, you had a $100 million asset write-up and a tax rate of 40%.
• The seller has total Assets of $200 million, total Liabilities of $150 million, and Shareholders’ Equity of $50 million

Answer 3

Deferred Tax Asset = Asset Write-Down * Tax Rate
Deferred Tax Liability = Asset Write-Up * Tax Rate
- assets up 200 mil, liabilities up 150 mil
- cash down 500 mil, but asset write-up means assets up 100mil
- debt up 500 mil, DTL up 40 mil
Assets down total 200 million, L+E up 690 million.
- so need goodwill and OIA of 890 million

Question 4

Could you get DTLs and DTAs in an Asset Purchase?

Answer 4

No, because in an asset purchase, book basis of assets always matches the tax basis.
- DTLs and DTAs get created in stock purchases because the book values of assets are written up or written down, but tax values are not.

Question 5

How’d you factor in DTLs into forward projections in a merger model?

Answer 5

Create a book vs cash tax schedule and figure what company owes in taxes based on pre-tax income on its books

Then determine what it actually pays due to NOLs and new DNA expenses.
- if cash tax expense > book tax expense, record this as a decrease to the DTL on the balance sheet and vice versa.