Assignment 1.2: Estimating Goodwill 1

Assignment 1.2: Estimating Goodwill

Asia Monday

Jones International University

June 8, 2012

Estimating Goodwill 2

Abstract

The purpose of this assignment is to answer questions Exercise 1-2: Estimating Goodwill and

Valuation and Exercise 1-3: Estimated and Actual Goodwill.

Estimating Goodwill 3

Exercise 1-2: Estimating Goodwill and Valuation

Alpha Company is considering the purchase of Beta Company. Alpha has collected the following data about Beta:

Beta Company Estimated

Book Values Market Values

Total Identifiable Assets $585,000 750,000

Total Liabilities 320,000 320,000

Owners’ Equity $265,000

Cumulative total net cash earnings for the past five years of $850,000 includes extraordinary cash gains of $67,000 and nonrecurring cash losses of $48,000. Alpha Company expects a return on its investment of 15% and discounted over five years.

Required:

A. Compute (a) an offering price based on the information above that Alpha might be willing to pay, and (b) the amount of goodwill included in that price.

Normal earnings: $750,000- $320,000 x 15% = $64,500

Net Cash Earnings past 5 years: $850,000

Less: Extraordinary cash gains: ($67,000)

Add: Non-recurring cash losses: $48,000

Target's expected future earnings: $831,000

Annually cash earnings: ($831,000/5) $166,200

Expected future cash earnings at 15% rate in 5 years

($166,200)(3.35216) = $577,129 (estimated goodwill)

Implied offering price: $750,000 - $320,000 - $265,000+ $577,129 = $742,129

B. Compute the amount of goodwill actually recorded, assuming the negotiations result in a final purchase price of $625,000 cash.

$625,000- $265,000= $360,000

Exercise 1-3: Estimated and Actual Goodwill

Passion Company is trying to decide whether to acquire Desiree Inc. The following balance sheet for Desiree Inc. provides information about book values. Estimated market values are also listed, based upon Passion Company’s appraisals.

Desiree Inc. Desiree Inc.

Book Values Market Values

Current Assets $260,000 $ 260,000

Estimating Goodwill 4

Property, Plant & Equipment (net) 650,000 740,000

Total Assets $910,000 $1,000,000

Total Liabilities $400,000 $ 400,000

Common Stock, $10 par value 160,000

Retained Earnings 350,000

Total Liabilities and Equities $910,000

Passion Company expects that Desiree will earn approximately $150,000 per year in net income over the next five years. This income is higher than the 12% annual return on gross tangible assets considered to be the industry “norm.”

A. Compute an estimation of goodwill based on the information above that Passion might be willing to pay (include in its purchase price), under each of the following additional assumptions:

Normal earnings: $1,000,000- $400,000 x 12% = $72000

(1) Passion is willing to pay for excess earnings for an expected life of 5 years (un-discounted).

Expected future earnings: $150000

Excess earnings: $150000-$72000 = $78000

Un-discounted: ($78,000)(5 years) = $390,000 goodwill

(2) Passion is willing to pay for excess earnings for an expected life of 5 years, which should be capitalized at the industry normal rate of return.

Discount rate 12% at 5 years: 3.60478

($78,000)(3.60478) = $281,173

(3) Excess earnings are expected to last indefinitely, but Passion demands a higher rate of return of 20% because of the risk involved.

$78,000/ 0.20

B. Comment on the relative merits of the three alternatives in part (A) above.

Alternative one provides a more in depth calculation to provide the suggestion to Passion that this will be the price to pay on a high end cost. Alternative two provides Passion with discounted rate at which should be the most cost effective method. Alternative three is a shorthand solution towards figuring out the rate as if it were to be un-discounted.

C. Determine the amount of goodwill to be recorded on the books if Passion pays $800,000 cash and assumes Desiree’s liabilities.

$800,000- ($1,000,000- $400,000) = $200,000

Estimating Goodwill 5

Estimating Goodwill 6

References

Remember to put your references in alphabetical order by author. If one of your references

begins with the word "The," put the rest of the name first and insert a comma, followed

by the word “The” (example – Associated Press, The.).

Author’s Last Name, First Initial. (year). Title of article. Journal Name, 8(1), 33-48. doi:

10.1242/66492344567 (Example of a journal article with a DOI – if the article also

has a URL, only list the DOI, not both. Do not end the DOI with a period.)

Author's Last Name, First Initial. (year). Title of article/Internet page. Retrieved Month date,

year, from http://completeURLhere (Example of an Internet source – if no date is

given on the internet page use: (n.d.). in place of the year. Do not end the URL with

a period.)

Author's Last Name, First Initial. (year). Title of book. City, ST: Publisher. (Example of a book)

Author's Last Name, First Initial. (year, Season). Title of article. Magazine Name, 12(8), 27.

(Example of a magazine article) - Note – only capitalize the proper nouns in the title of

the article; capitalize all the words in the magazine name; the 12 is where the volume

Estimating Goodwill 7

number goes, the 8 is where the issue number goes, the 27 is where the page number

goes.

Berube, M. S., ed. (1989). The American heritage dictionary. New York: Dell. (Example of a

dictionary)

Bird, I. (1973). A lady's life in the Rocky Mountains (Reprint ed.). New York: Ballantine Books.

(Example of a book – one author)

Leonard, S. J., & Noel, T. J. (1990). Denver: Mining camp to metropolis. Niwot, CO: University

Press of Colorado. (Example of a book – more than one author)

Morson, B., & Frazier, D. (2000, December 7). For years, brown cloud fouls Denver image

[Electronic version]. Denver (Colorado) Rocky Mountain News. Retrieved on October 3,

2002, from http://insidedenver.com/millennium/1207stone.shtml (Example of a

newspaper article from an online version of the newspaper)

National Jewish Medical & Research Center. (2001, January 5). The 'Brown Cloud,' cold-

induced asthma, winter allergies and seasonal affective disorder around the corner as

winter approaches. Retrieved October 4, 2002, from http://www.njc.org/news/

winter1.html (Example of an organization as the author)