Principles of Finance: Unit 3, Tax Deduction Math

How do corporate tax deductions work? Like... what sort of expenses can they deduct, and for how much? Paging Uncle Sam...

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
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SubjectsFinance and Economics

Transcript

00:26

debt. you the wily CEO wonder gee whiz what if we bought lemonade lovers for

00:33

fifteen billion we'd be really big we'd get cheaper prices for our cups and

00:38

sugar and rent and be the brand in lemonade. well because you took this

00:43

course on Finance from your fine loving people at shmoop here you can easily do

00:48

the math. pro forma doesn't mean you get paid making a living as a former. pro

00:53

forma means combined. so all this would be great if you could use a high [pro forma explained]

00:58

multiple stock of your own to buy them. but your stock trades at only ten times

01:02

earnings and to be bought they want 20 times their earnings .you would suffer

01:07

huge dilution if you used your own stock. if you pay cash well they'll take a

01:12

lower multiple. 15 ish times earnings well cash always has less risk obviously

01:17

than stock, so you try to figure out how you can raise fifteen billion dollars of

01:22

cash. we've been through the basics of Investment Banking 101, but here the

01:26

focus is on free cash flow and debt repayment. so let's dream a little dream

01:31

and say we borrow all fifteen billion dollars in cash. well some idiot or

01:36

visionary is willing to loan us all that money for the leveraged buyout of

01:41

lemonade lovers and charge us five percent interest on the loan. yes we are

01:46

massively simplifying here. Throeau has nothing on us. quick math tells us that [Henry David Thoreau pictured]

01:51

five percent interest on fifteen billion dollars is seven hundred fifty million

01:55

dollars a year of interest. but that interest will shrink as we pay down our

01:59

principal, right? and we know that if we can swing year one and start to really

02:04

pay down that principal, well this LBO for leveraged buyout should work great.

02:09

so let's look at year one right here well look how different things compare

02:12

here with the first iteration with no debt. in the no debt scenario we were

02:18

paying 420 million dollars in taxes. now we're paying just a hundred ninety five

02:24

million, because interest is deductible from taxes. the government essentially

02:29

split our interest costs with us. nice of them and in doing so it made the LBO [uncle sam asks for more taxes]

02:33

work mathematically. you can assume that most of the net income of four hundred

02:38

fifty five million there is free cash, and our lemonade business has very

02:42

little capital expenditures which would cloud the net income a versus free cash

02:46

flow story, so in year one we can take say four hundred million dollars of our

02:51

free cash and pay down our debt principle to just fourteen point six

02:56

billion. well in year two with less principle to pay down our interest

03:00

expenses go down, and by year five we're sitting pretty fat and happy even

03:04

assuming no growth or additional synergies from the merger that we just

03:08

did here it's an acquisition, and note that we only included a relatively small

03:13

expense savings of two hundred million dollars by way of being able to buy our [spreadsheet showing expenses before and after merger]

03:16

supplies a bit cheaper with huge wal-mart like scale and the lemonade biz.

03:21

it's likely that there are more savings we'll be able to find and more revenue

03:25

growth opportunities to be had as well. [fizzy lemonade next to regular lemonade pictured on a shelf]