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Estimated and Actual Goodwill
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 Inc. Desiree Inc.
Book Values Market Values
Current assets \$260,000 \$ 260,000
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 tangible
assets considered to be the industry “norm.”
Required:
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:
(1) Passion is willing to pay for excess earnings for an expected life of five years (undiscounted).
(2) Passion is willing to pay for excess earnings for an expected life of five years, which
should be capitalized at the industry normal rate of return.
(3) Excess earnings are expected to last indefinitely, but Passion demands a higher rate
of return of 20% because of the risk involved.
B. Comment on the relative merits of the three alternatives in part (A) above.
C. Determine the amount of goodwill to be recorded on the books if Passion pays \$800,000
cash and assumes Desiree’s liabilities.

am not sure

Can anyone answer this question? I'm a little confused too. Thank you!

A. (1) 12% x (\$1,000,000-400,000) = \$72,000 normal earnings.
Expected future earnings = \$150,000.
Excess earnings = \$150,000 - 72,000 = \$78,000.
Excess earnings x 5 years = \$390,000 goodwill.
(2) \$78,000 x 3.60478 (discount rate of 12% at 5 years) = \$281,173 goodwill.
(3) \$78,000 / 20% = \$390,000 goodwill.

C. \$800,000 - (\$1,000,000 - 400,000) = \$200,000 goodwill.