Question

Peters Corporation acquires all of the voting shares of Stefan Company by issuing 500,000 shares of $1 par common stock valued at $10,000,000. Included in the agreement is a contingency guaranteeing the former shareholders of Stefan that Peters' shares will be worth at least $18 per share after one year. If the shares are worth less, Peters will pay the former shareholders of Stefan enough cash to reimburse then for the decline in value below $18 per share. Peters estimates that there is a 5% chance that the stock value will be $16 at the end on one year, and a 95% chance that the stock value will be $18 per share or higher. A discount rate of 10% is appropriate.

Which amount below is closest to the value of the contingent consideration at the date of acquisition?

A.) $1,000,000

B.) $45,000

C.) $50,000

D.) $865,000

Answer 1

B.$45,000.

working:

gross value of consideration (500,000 shares * ($18-16) *5%)	$50,000
discount rate (1 / (1.10)^1) since 10% is the appropriate rate	0.90909
total contingent consideration (50,000*0.909090)	45,454

45,454 is closest to $45,000.

Answer 2

To calculate the value of the contingent consideration, we need to determine the expected value of the payment that Peters would make to the former shareholders of Stefan in case the stock value falls below $18 per share after one year.

Given: Number of shares issued: 500,000 Par value per share: $1 Total value of shares issued: $10,000,000 Probability of stock value being $16: 5% Probability of stock value being $18 or higher: 95% Discount rate: 10%

First, let's calculate the expected value of the contingent consideration. We need to consider the probabilities and discount the potential payment by the appropriate discount rate.

Payment = (Probability of stock value being below $18) * (Expected payment amount)

To find the expected payment amount, we need to calculate the potential payment for each scenario (stock value below $18) and weigh them by their probabilities.

Potential payment amount: For stock value of $16, the potential payment would be the difference between the guaranteed value of $18 and the actual value of $16 per share: Potential payment for $16 stock value = ($18 - $16) * Number of shares issued = $2 * 500,000 = $1,000,000

Expected payment amount: Expected payment = (Probability of stock value being $16) * (Potential payment for $16 stock value) = 0.05 * $1,000,000 = $50,000

Now, let's discount the expected payment to the date of acquisition using the discount rate of 10%:

Value of the contingent consideration = Expected payment / (1 + Discount rate) = $50,000 / (1 + 0.10) = $50,000 / 1.10 ≈ $45,455.45

Therefore, the value of the contingent consideration at the date of acquisition is closest to $45,000 (option B).