Abaco is planning to acquire Cozumel Airlines, a freestanding C corporation, in expectation that new management can be brought in to achieve substantial operating efficiencies. You have been retained to advise Abaco on how to structure the acquisition.
Two graduate school friends, Monique and Denise, own Cozumel Airlines. Together, they have a $ 1 million basis in their Cozumel Airlines stock. Both Monique and Denise have held their Cozumel Airlines stock for several years but must sell their stock for nontax reasons. Cozumel Airlines’ tax- basis balance sheet contains $ 14 million in assets, no liabilities, and no net operating loss carryovers. All par-ties agree that Cozumel Airlines would be worth $ 20 million to Abaco with no step- up in Cozumel’s inside ( asset) basis, but $ 21.25 million if its inside ( asset) basis was stepped up to fair market value. Monique and Denise each face a 40% tax rate on ordinary income and a 20% tax rate on capital gains. The corporate tax rate is 35%.
Option 1: Abaco buys outright all Cozumel Airlines’ assets for $ 18 million— a taxable asset acquisition. Cozumel Airlines pays resulting taxes on the sale, if any, and distributes the proceeds to Monique and Denise in a complete liquidation.
Option 2: Abaco pays Monique and Denise $ _____ million in cash for their stock in Cozumel and does not make a Section 338 election.
a. How much after- tax cash will Monique and Denise get in aggregate if Option 1 is chosen?
b. In Option 2, how much cash would Abaco have to pay to make Monique and Denise indifferent between Options 1 and 2?
c. What is Abaco’s net present value if Option 1 is chosen?
d. What is Abaco’s net present value if Option 2 is chosen— based on your answer to part b?