On January 1, 2011, Acme Co. is considering purchasing a 40 percent ownership interest in PHC Co., a privately held enterprise, for $700,000. PHC predicts its profit will be $185,000 in 2011, projects a 10 percent annual increase in profits in each of the next four years, and expects to pay a steady annual dividend of $30,000 for the foreseeable future. Because PHC has on its books a patent that is undervalued by $375,000, Acme realizes that it will have an additional amortization expense of $15,000 per year over the next 10 years—the patent’s estimated useful life. All of PHC’s other assets and liabilities have book values that approximate market values. Acme uses the equity method for its investment in PHC.
1. Using an Excel spreadsheet, set the following values in cells:
• Acme’s cost of investment in PHC.
• Percentage acquired.
• First-year PHC reported income.
• Projected growth rate in income.
• PHC annual dividends.
• Annual excess patent amortization.
2. Referring to the values in (1), prepare the following schedules using columns for the years 2011 through 2015.
• Acme’s equity in PHC earnings with rows showing these:
• Acme’s share of PHC reported income.
• Amortization expense.
• Acme’s equity in PHC earnings.
• Acme’s Investment in PHC balance with rows showing the following:
• Beginning balance.
• Equity earnings.
• Ending balance.
• Return on beginning investment balance = Equity earnings/Beginning investment balance in each year.
3. Given the preceding values, compute the average of the projected returns on beginning investment balances for the first five years of Acme’s investment in PHC. What is the maximum Acme can pay for PHC if it wishes to earn at least a 10 percent average return on beginning investment balance?