Question

EXERCISE 1-3 Estimated and Actual Goodwill LO 7 Passion Company is trying to decide whether or not 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 Desiree Inc. Inc. Book Market Values Values Current assets $260,000 $ 260,000 Property, plant & 650,000 equipment (net) _740,000 Total assets $910,000 $1,000,000 Total liabilities $400,000 $ 400,000 Common stock, 160,000 $10 par value Retained earnings _350,000 Total liabilities $910,000 and equities

Answer 1

A Total Tangible Assets at Market Value $1,000,000 Normal rate of return on Tangible 12% Normal earning 120000 =$1000,000*12% Expected earning per year over 5 years $150,000 Excess earnings $30,000 =150000-120000 Note: We have taken Total tangible assets (1000000) for calulating normal earning as mentioned in question. Alternatively Net Assets/Capital (1000000-400000 = 600000) can also be taken A-1 Computation of goodwill when Passion is willing to pay for excess earnings for an expected life of 5 years (undiscounted) Excess earnings (a) Years (6) Goodwill (a*b) $30,000 5 $150,000 $30000*5 years Computation of goodwill when Passion is willing to pay for for excess earnings for an expected life of 5 years, which A-2 should be capitalized at the industry normal rate of return. Excess earnings (a) $30,000 Discount rate(Present Value annuity 3.60478 Factor) 12% at 5 years (b) Goodwill (a*b) $108,143.40 Computation of goodwill when earnings are expected to last indefinitely, but Passion demands a higher rate of return of A-3 20% because of the risk involved Excess earnings (a) $30,000 Expected return (b) 20% Goodwill (a/b) $150,000.00

Alternative Solution for Part A - (If Net Assets are taken instead of Total Tangible)

B Comment on the relative merits of the three alternatives in part (A) above. Option 1 (A1) provides a more provides a detailed in depth calculation of Goodwill based on expected eaning for 5 years. This shows the highest price Passion Company might pay for Goodwill. Option 2 (A2) calculates the goodwill using the discounted rates. In this value is lowest. This is the most cost effective method for Passion Company. Option 3 (A3) is provides the goodwill if excess earning were to be un-discounted at higher expected return. It takes into account expected rate of return с Calculation of goodwill to be recorded if Passion pays $800,000 cash and assumes Desiree's liabilities. Total Tangible Assets at Market Value Less: Total Liabilities Net Assets/Capital (a) $1,000,000 ($400,000) $600,000 Cash paid (b) $800,000 Goodwill (b-a) $200,000.00

А Total Tangible Assets at Market Value Less: Total Liabilities Net Assets/Capital (a) Normal rate of return on Tangible Normal earning Expected earning per year over 5 years Excess earnings $1,000,000 ($400,000) $600,000 12% $72,000 -$1000,000*12% $150,000 $78,000 -150000-120000 A-1 Computation of goodwill when Passion is willing to pay for excess earnings for an expected life of 5 years (undiscounted) $ Excess earnings (a) Years (b) Goodwill (a*b) 78,000 5 390,000 -$30000*5 years S A-2 Computation of goodwill when Passion is willing to pay for for excess earnings for an expected life of 5 years, which should be capitalized at the industry normal rate of return. $ 78,000 Excess earnings (a) Discount rate(Present Value annuity Factor) 12% at 5 years (b) Goodwill (a*b) 3.60478 S 281,173 Computation of goodwill when earnings are expected to last indefinitely, but Passion demands a higher rate of return A-3 of 20% because of the risk involved Excess earnings (a) $ 78,000 Expected return (b) 20% Goodwill (a/b) $ 390,000