# Pg.102 Q5.C Compute the diff. bet co. A and co. B

co. A used the purchase method and co. B used the pool method. This question asks you to calculate the Cash Flow difference. My logic is that the cash flow would INCREASE for the purchase method. Why? Because: CashFlow = (S - C - D)*(1-TR%) + D And CashFlow *ALWAYS* increase with D. Solve and simplify the equation yourself using test variables (i.e. S=\$10, C=\$1, TR=33.333% —> this equation simplifies to CashFlow = 6 + Dep./3 —> the cashflow always increase with depreciation! However, the answer in the back of the book says the exact opposite. It reads that “Cash flow is unaffected.” Did AIMR screw up?

My question deals with Question 5.c on page 102 of the FSA book: co. A used the purchase method and co. B used the pool method. This question asks you to calculate the Cash Flow difference. My logic is that the cash flow would INCREASE for the purchase method. Why? Because: CashFlow = (S - C - D)*(1-TR%) + D And CashFlow *ALWAYS* increase with D. Solve and simplify the equation yourself using test variables (i.e. S=\$10, C=\$1, TR=33.333% —> this equation simplifies to CashFlow = 6 + Dep./3 —> the cashflow always increase with depreciation! However, the answer in the back of the book says the exact opposite. It reads that “Cash flow is unaffected.” Did AIMR screw up?

I think you’re losing the forest for the trees. Cash flow… How much cash comes in has nothing to do with the difference in pool vs purchase.

In case of Purchase method if the excess paid amount is recognized as some identifiable tangible asset which can be amortized or depreciated, then in that case the operating cash flow is different from the pooling method. This happens because the tax paid is dependent on the depreciation expense.

To go along with your logic (purchase method produces higher dep’n, therefore it should have higher CF’s) remember the fact that NI, which is there before you add back depreciation will be LOWER with the purchase method, therefore cash flows between purchase and pooling should be the same. to summarize Purchase method has lower NI but Higher Dep’n Pooling method has higher NI but lower Dep’n

Let me illustrate: Net Income = EBIT - EBIT*T (Tax component, assuming no interest expense) Now EBIT for purchase method is lower due to higher dep, so the tax is lower. While EBIT for pooling method is higher so the tax is higher. The amount EBIT*T is an actual cash outflow which might occur assuming the taxes reported is taxes paid. Now when we add back Depreciation it removes the dep component from EBIT but doesn’t impact the tax component. So cash flow will be: EBIT + Dep - EBIT*T (Tax component) Eventhough the first component in the above formula is same for both purchasing and pooling but the tax component differes due to increased depreciation for purchasing.

So the idea here is that JoeyD company owns a truck which I have been nicely depreciating over 5 years for my tax statements but then Kabhii company buys me, says the truck is worth lots more than I said it was worth in my prior filings so the combined company should get a bigger tax deduction than I could get on my own or in a pooling. Does that sound right?

Yes. But if the excess amount is recognized as goodwill then it won’t impact the cash flows as the goodwill is not amortized but impaired.

Guys - the question asks *PRETAX INCOME*, and in this case, IT DOESN’T MATTER!!! However, if they were asking post-tax, then for sure, I and ABHII WERE RIGHT!!!

Actually, the question does *NOT* ask for the pre-tax CF. I still think that there is something wrong here…

JoeyDVivre: I don’t agree with you. There’s something wrong with the book’s explanation. Only you and I disagree with this. The question reads: 5. Company A and Company B are identical in all respects other than how they account for intercorporate investments. Both made their first acquisition on Jan. 1, 20x1 (of Company C and D, respectively, which are identical in all respects). in each case, 100% of the outstanding stock of the investee was acquired. Company A accounted for its acquisition as a purchase whereas Company B used the pooling method. assume that the fair value of each investee’s assets exceeded book value by \$100,000, which is assigned to assets that can be depreciated on a straight-line basis over 4 years. Compute the *DIFFERENCE* between Company A and Company B on each of the following measures on their year-end 20X1 financial statements. a. Pretax earnings b. Assets c. Cash Flow NOTE: They DID NOT say pre-tax cash flow!!! CASH FLOWS INCREASE for the purchased (and not pooled) company due to tax deductions. CashFlow = (S - C - D)*(1-TR%) + D Play around with that equation, and tell me what you see. I highly recommend you to show your work on this forum. You’ll be amazed. I’M RIGHT AND YOU’RE WRONG.

Patkeenan, CF is reduced by D*(1-T%), but then you add the full D back. This is effectively like adding T%*D. Please please please play around with some numbers and you’ll see for yourself that YOU’RE WRONG, and I’M RIGHT! The CF is higher for PURCHASING! patkeenan Wrote: ------------------------------------------------------- > To go along with your logic (purchase method > produces higher dep’n, therefore it should have > higher CF’s) remember the fact that NI, which is > there before you add back depreciation will be > LOWER with the purchase method, therefore cash > flows between purchase and pooling should be the > same. > > to summarize > > Purchase method has lower NI but Higher Dep’n > Pooling method has higher NI but lower Dep’n

No, EBITDA is different and so is EBIT! kabhii Wrote: ------------------------------------------------------- > Let me illustrate: > > Net Income = EBIT - EBIT*T (Tax component, > assuming no interest expense) > > Now EBIT for purchase method is lower due to > higher dep, so the tax is lower. While EBIT for > pooling method is higher so the tax is higher. > > The amount EBIT*T is an actual cash outflow which > might occur assuming the taxes reported is taxes > paid. > > Now when we add back Depreciation it removes the > dep component from EBIT but doesn’t impact the tax > component. > > So cash flow will be: > EBIT + Dep - EBIT*T (Tax component) > > Eventhough the first component in the above > formula is same for both purchasing and pooling > but the tax component differes due to increased > depreciation for purchasing.

Do you mean to say that EBITDA is different because of depreciation or for some other reason?