P Company is considering the acquisition of S Inc. To assess the amount it might

Question

P Company is considering the acquisition of S Inc. To assess the amount it might be willing to pay, P makes the following computations and assumptions: A. S Inc. has identifiable assets with a total fair value of $8,000,000 and liabilities of $5,300,000. The assets include office equipment with a fair value approximating book value, buildings with a fair value 30% higher than book value, and land with a fair value 60% higher than book value. The remaining lives of the assets are deemed to be approximately equal to those used by Barkley, Inc. B. S Inc.'s pretax incomes for the years 2010 through 2012 were $700,000, $900,000, and $550,000, respectively. P believes that an average of these earnings represents a fair estimate of annual earnings for the indefinite future. However, it may need to consider adjustments for the following items included in pretax earnings: Depreciation on Buildings (each year) 580,000 Depreciation on Equipment (each year) 30,000 Extraordinary Loss (year 2012) 200,000 Salary expense (each year) 150,000 C. The normal rate of return on net assets for the industry is 20%. Required: Assume further that P feels that it must earn a 15% return on its investment, and that goodwill is determined by capitalizing excess earnings. Based on these assumptions, calculate a reasonable offering price for S, Inc.

Explanation / Answer

P Company a Fair Value of Assets $8,000,000 fair Value of liabilities $5,300,000 fair value of net assets $2,700,000 Normal rate of return 15% Normal earnings $405,000 Estimate the expected future earnings of the target Pretax Income of S inc 2010 $700,000 Less additional depr on Building $580000*30% $174,000 Additional Earnings for 2010 $526,000 Pretax Income of S inc 2011 $900,000 Less additional depr on Building $174,000 $580000*30% Additional Earnings for 201 $726,000 Pretax Income of S inc 2012 $550,000 Less additional depr on Building $174,000 $580000*30% Additional Earnings for 2012 $376,000 Add :extraordinary Loss $200,000 Additional Earnings for 2012 $576,000 Total Three Yr adjusted earnings $1,828,000 Three yr average adjusted earnings $609,333 Therefore the excess earnings Expected Average Earnings $609,333 Less Normal earnings $405,000 Excess $204,333 b Excess earnings of target $204,333 PV factor annuity 3 yrs 15% 2.28323 Estimated Goodwill $466,538.24 Fair Value of net Assets $2,700,000 Offering Price $3,166,538.24

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