Patrick Company is trying to decide whether to acquire Narineh Inc. Patrick Company expects that Narineh will earn approximately $200,000 per year in net income over the next five years. This income is higher than the 14% annual return on assets considered to be the industry ""norm."""
If the fair value of Narineh Inc. assets equal to $1,400,000. What is the estimation of goodwill if Patrick is willing to pay for excess earnings for an expected life of 4 years? *
$16,000
$18,000
$42,000
$22,000
If the fair value of Narineh Inc. assets equal to $1,400,000. What is the estimation of goodwill if excess earnings are expected to last indefinitely, but Patrick demands a higher rate of return of 10% because of the risk involved? *
$40,000
$70,000
$50,000
$32,500
To calculate the estimation of goodwill, we need to find the excess earnings of Narineh Inc., which is the difference between its expected net income and the industry norm return on assets.
1) Estimation of goodwill with an expected life of 4 years:
The excess earnings over the 5-year period would be:
Excess Earnings = Expected Net Income - (Industry Norm Return on Assets x Fair Value of Assets)
= $200,000 - (14% x $1,400,000)
= $200,000 - $196,000
= $4,000
Since the excess earnings are expected to last for 4 years, the estimation of goodwill would be the present value of these excess earnings. Assuming a discount rate of 14% (same as the industry norm return on assets), we can calculate the present value of $4,000 over 4 years.
Using a financial calculator or formula, the present value of $4,000 over 4 years at a 14% discount rate is approximately $16,000.
Therefore, the estimation of goodwill with an expected life of 4 years is $16,000.
2) Estimation of goodwill with excess earnings expected to last indefinitely:
In this scenario, since the excess earnings are expected to last indefinitely, we need to calculate the present value of these excess earnings using a discount rate that reflects the higher rate of return demanded by Patrick Company. The higher rate of return is 10%.
Using the same formula or financial calculator, we can calculate the present value of $200,000 per year indefinitely at a 10% discount rate.
The present value of perpetual cash flow or the estimated goodwill would be:
Present Value of Excess Earnings = Excess Earnings / Discount Rate
= $200,000 / 10%
= $2,000,000
Therefore, the estimation of goodwill with excess earnings expected to last indefinitely, but with a 10% higher rate of return, is $2,000,000.
Based on the options given, neither $16,000 nor $2,000,000 matches the answer choices.