Macho Inc. has recently become interested in acquiring a South American plant to handle many of its production functions in that market. One possible candidate is De Fuentes SA, a closely held corporation, whose owners have decided to sell their business if a proper settlement can be obtained. De Fuentes\; statement of financial position is as follows:
Current assets .................... $125,000
Fair value-net income investments ............. 55,000
Buildings (net) ..................... 405,000
Total assets ...................... $585,000
Current liabilities ................... $85,000
Notes payable .................... 105,000
Share capital .................... 225,000
Retained earnings .................. 170,000
Total equities ..................... $585,000
Macho has hired Yardon Appraisal Corporation to determine the proper price to pay for De Fuentes SA. The appraisal firm finds that the fair value - net income investments have a fair value of $75,000 and that inventory is understated by $40,000. All other assets and liabilities have book values that approximate their fair values. An examination of the company's income for the last four years indicates that the net income has steadily increased. In 2014, the company had a net operating income of $110,000, and this income should increase by 15% each year over the next four years. Macho believes that a normal return in this type of business is 15% on net assets. The asset investment in the South American plant is expected to stay the same for the next four years.
Instructions
(a) Yard on Appraisal Corporation has indicated that the company's fair value can be estimated in several ways. Prepare estimates of the value of De Fuentes SA, with the value based on each of the following independent assumptions:
1. Goodwill is based on the purchase of average excess earnings over the next four years.
2. Goodwill is equal to the capitalization of average excess earnings of De Fuentes SA at 30%.
3. Goodwill is equal to the present value of the average excess earnings over the next four years discounted at 15%.
4. The value of the business is based on the capitalization of future excess earnings of De Fuentes SA at 16%.
(b) De Fuentes SA is willing to sell the business for $1 million. What advice should Yardon Appraisal give Macho in regard to this offer?
(c) If Macho were to pay $850,000 to purchase the assets and assume the liabilities of De Fuentes SA, how would this transaction be reflected on Macho's books?