The Valuation of Tax Shields Induced by Asset Step-ups in Corporate Acquisitions

1. Executive Summary Borrowing is not the only instrument that shields corporate income against taxes. Apart from interest payments, any other expense, but especially depreciation and amortization play a major role in determining the corporate tax liability. Asset step-up induced depreciation and amortization tax shields are created in the framework of corporate mergers and acquisitions. Asset step-ups allow the acquirer to increase (step-up) the pre-acquisition tax basis of acquired assets to the fair market value or the purchase price. The stepped up tax basis is fully depreciable/amortizable and thus provides additional tax shields and hence value, for the combined entity after the transaction. In his empirical study of tax value in management buyouts, Kaplan (1989) estimates that for the companies in his sample, which chose to step-up the asset basis, the median value of the asset step-up is approximately 30 percent of the premium paid. To derive these figures, Kaplan (1989) examines a sample of 76 management buyouts of publicly held companies completed in the period 1980 - 1986. However, the Tax Reform Act of 1986 has reduced tax benefits of asset step-ups in mergers and acquisitions. Nevertheless, asset step-up structured transactions still occur on a regular basis, in particular for acquisitions of corporate subsidiaries and S corporations. Still, asset step-ups can contribute a significant amount of value in the context of corporate acquisitions. As Erickson and Wang (2000) note, Cox Communications could generate asset step-ups worth about $350 million when it acquired the cable television business of Gannett Company for $2.7 billion in 1999.3 In their analysis, Erickson and Wang (2000) also find (at least) weak evidence that deal premiums in acquisitions of subsidiaries are higher in a case in which the deal is structured in a way that enables assets to be stepped up, thus indicating the additional value of asset step-ups. Moreover, Maydew et al. (1999) note that the value of asset step-ups is regularly evaluated by sellers in the context of divestitures of corporate subsidiaries in order to outline this information in the sales materials provided to potential buyers.4 Accordingly, the valuation of asset step-up induced depreciation tax shields via appropriate discount rates is a fundamental issue in the context of mergers and acquisitions. To our knowledge, there is no consistent approach in corporate financial literature to value the tax shields of asset step-up based depreciations. Not even a practical model of how to determine appropriate discount rates for these tax shields can be found. Indeed, some empirical studies dealing with tax effects corporate acquisitions use specific rates to discount asset step-up induced depreciations. However, those studies do not derive such rates via analyses, but determine them arbitrarily. The contribution of this paper is to discuss all relevant parameters and to provide a consistent approach for the derivation of these discount rates. We start with the risk-less after-corporate tax interest rate, which is, according to Ruback (1986), the appropriate rate to discount riskless after-tax corporate cash flows, such as "regular" depreciation benefits. Ruback (1986) assumes depreciation tax shields to be free of risk. By dissolving Ruback's assumptions, we derive corresponding discount rates via a case differentiation. For valuations conducted in the framework of the Adjusted Present Value approach we show that a discount rate r* is adequate to value step-up induced depreciation benefits. In the case that the valuation of the tax shield of asset step-ups is not conducted via the Adjusted Present Value approach, the tax advantage of debt is not accounted for in a separate term and thus has to be included in the discount rate of the cash flows to be valued. When accounting for its debt tax benefit, the depreciation tax shield can also be valued standalone.…