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.
Can anyone answer this question? I'm a little confused too. Thank you!
am not sure
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.
Estimated and Actual Goodwill
To estimate the goodwill based on the information provided, we need to consider the excess earnings of Desiree Inc. over the industry "norm" return on tangible assets. Goodwill represents the intangible value of a business, such as its reputation, brand, and customer relationships.
A. Let's calculate the estimation of goodwill under each of the given assumptions:
1. To estimate the goodwill without discounting the excess earnings, we can simply subtract the present value of the expected earnings from the market value of Desiree Inc.
First, we need to calculate the present value of the expected earnings over five years. Assuming the earnings of $150,000 will be the same each year, the present value can be calculated using the formula for the present value of an annuity:
Present Value = Annual Earnings / Discount Rate
Since there is no discount rate mentioned for this assumption, we can assume it to be zero. Therefore, the present value of the expected earnings is:
Present Value = $150,000 / 0% = $150,000
Now, we can calculate the estimated goodwill:
Estimated Goodwill = Market Value - Present Value
= $1,000,000 - $150,000
= $850,000
2. To estimate the goodwill by capitalizing the excess earnings at the industry normal rate of return, we need to calculate the present value of the expected earnings using the industry normal rate of return as the discount rate.
Using the formula for the present value of an annuity again:
Present Value = Annual Earnings / Discount Rate
The industry normal rate of return is given as 12%. So, the present value of the expected earnings is:
Present Value = $150,000 / 12%
= $1,250,000
Estimated Goodwill = Market Value - Present Value
= $1,000,000 - $1,250,000
= -$250,000
Since the present value of the expected earnings exceeds the market value, there would be no positive goodwill under this assumption.
3. To estimate the goodwill when excess earnings are expected to last indefinitely, but Passion demands a higher rate of return of 20% due to the risk involved, we need to calculate the present value of perpetuity.
Using the formula for the present value of a perpetuity:
Present Value = Annual Earnings / Discount Rate
The annual earnings are still $150,000, and the discount rate is 20%. So, the present value of perpetuity is:
Present Value = $150,000 / 20%
= $750,000
Estimated Goodwill = Market Value - Present Value
= $1,000,000 - $750,000
= $250,000
B. The relative merits of the three alternatives can be evaluated based on the estimated goodwill.
- Alternative 1: If Passion is willing to pay for excess earnings for an expected life of five years without discounting, the estimated goodwill is $850,000.
- Alternative 2: If Passion is willing to pay for excess earnings for an expected life of five years, capitalized at the industry normal rate of return, there would be no positive goodwill under this assumption.
- Alternative 3: If Passion demands a higher rate of return of 20% due to the risk involved and expects the excess earnings to last indefinitely, the estimated goodwill is $250,000.
Based on these estimates, Alternative 1 seems to have the highest goodwill value, followed by Alternative 3. Alternative 2 does not result in positive goodwill.
C. To determine the amount of goodwill to be recorded on the books if Passion pays $800,000 cash and assumes Desiree's liabilities, we need to calculate the excess of the purchase price over the fair value of Desiree's identifiable net assets.
The fair value of Desiree's identifiable net assets can be calculated as follows:
Fair Value of Identifiable Net Assets = Total Assets - Total Liabilities
= $1,000,000 - $400,000
= $600,000
Goodwill = Purchase Price - Fair Value of Identifiable Net Assets
= $800,000 - $600,000
= $200,000
Therefore, the amount of goodwill to be recorded on the books would be $200,000.