Consider the acquisitions by Germany-based media company EM.TV & Merchandising AG of the Jim Henson Company, creator of The Muppet Show, and Speed Investments Ltd., co-owner of the commercial rights to Formula One motor racing. At the end of the 1990s, EM.TV pursued a strategy of aggressive growth through the acquisitions of TV and marketing rights for well-known cartoon characters, such as The Flintstones, and popular sporting events. After its initial public offering on the Neuer Markt segment of the German Stock Exchange in October 1997, EM.TV’s share price soared from €0.35 (split-adjusted) to a high of just above €120 in February 2000. Its high share price helped EM.TV to finance several acquisitions through a secondary stock offering and the issuance of convertible debt. In March and May 2000, respectively, the company made its two largest acquisitions with the intention of expanding its international reputation.

The company acquired the Jim Henson Company for €699 million and Speed Investment for €1.55 billion.

At the time of the acquisition, Speed Investment’s book value of equity was negative and the amount of goodwill that EM.TV recognized on the investment was €2.07 billion. The rationale of capitalizing this amount of goodwill on EM.TV’s balance sheet is that it could truly represent the future economic benefits that EM.TV expects to receive from its investment but that are not directly attributable to the investment’s recorded assets and liabilities. However, the analyst should consider the possibility that EM.TV has overpaid for its new investments, especially in times where its managers are flush with free cash flow.

At the end of the fiscal year, when EM.TV’s share price had already declined to €5.49, the company was forced to admit that it had overpaid for its latest acquisitions. Goodwill impairment charges for the year ending in December 2000 amounted to €340 million for the Jim Henson Company and €600 million for Speed Investment. In its annual report, EM.TV commented that “the salient factor for the write-offs was that, at the time of the acquisitions, the expert valuation was determined by the positive expectations of the capital markets. This was particularly expressed through the use of corresponding multiples.” Despite the large write-offs, a considerable amount of goodwill, related to the acquisition of Speed Investment, remained part of EM.TV’s assets.

This amount of €1.41 billion was equal to 170 percent of EM.TV’s book value of equity. Given the questionable financial health of Speed Investment, did the initial €2.07 billion of goodwill ever represent a true economic asset? Was it reasonable to expect to receive €2.07 billion in future economic benefits from a firm that had not been able to earn profits in the past? If not, was the €600 million write-down adequate?

1. What balance sheet adjustments should an analyst make if she decided to record an additional write-down of €1.41 billion in the December 2000 financials?

2. What effect would this additional write-down have on EM.TV’s depreciation expense in 2001?

(Assume that the adjustments to EM.TV’s balance sheet are in conformity with current IFRS Standards.)