Question

EXERCISE 1-1 Estimating Goodwill and Potential Offering Price LO 7 Plantation Homes Company is considering the acquisition of Condominiums, Inc. early in 2020. To assess the amount it might be willing to pay, Plantation Homes makes the following computations and assumptions. A. Condominiums, Inc. has identifiable assets with a total fair value of $15,000,000 and liabilities of $8,800,000. 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 75% higher than book value. The remaining lives of the assets are deemed to be approximately equal to those used by Condominiums, Inc. B. Condominiums, Inc.'s pretax incomes for the years 2017 through 2019 were $1,200,000, $1,500,000, and $950,000, respectively. Plantation Homes 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 to the following items included in pretax earnings: Depreciation on buildings 960,000 (each year) Depreciation on equipment 50,000 (each year)

Answer 1

Answer:

Part A            

Normal earnings for similar firms = ($15,000,000 - $8,800,000) x 15% = $930,000

              Expected earnings of target:

              Pretax income of Condominiums, Inc., 2017 $1,200,000

  Subtract: Additional depreciation on building ($960,000 x 30%) (288,000)

              Target’s adjusted earnings, 2017 912,000

              Pretax income of Condominiums, Inc., 2018 $1,500,000

  Subtract: Additional depreciation on building     (288,000)

              Target’s adjusted earnings, 2018 1,212,000

  Pretax income of Condominiums, Inc., 2019 $950,000

              Add: Extraordinary loss   300,000

  Subtract: Additional depreciation on building   (288,000)

              Target’s adjusted earnings, 2019   962,000

  Target’s three year total adjusted earnings        3,086,000

  Target’s three year average adjusted earnings ($3,086,000 ÷ 3)      1,028,667

              Excess earnings of target = $1,028,667 - $930,000 = $98,667 per year

  Present value of excess earnings (perpetuity) at 25%:                =    $394,668            (Estimated Goodwill)

              Implied offering price = $15,000,000 – $8,800,000 + $394,668 = $6,594,668.

Part B            

Excess earnings of target (same as in Part A) = $98,667

Present value of excess earnings (ordinary annuity) for three years at 15%:

$98,667 ´ 2.28323 = $225,279

Implied offering price = $15,000,000 – $8,800,000 + $225,279 = $6,425,279.

The sales commissions and depreciation on equipment are expected to continue at the same rate, and thus do not necessitate adjustments.