APITAL COST ALLOWANCE $-$ CASE ONE

Patterson Traders Inc. has developed substantial cash reserves after several successive years

profitable

operations. The company intends to use those reserves to diversify and has targeted two businesses for possible acquisition. Both target businesses are corpora$-$ tions.

Patterson has stated that it wants to acquire only the individual assets of any business it acquires, rather than the shares of the corporation that owns the assets. In addition, Patterson has a strong cash position and so has no desire to incur debt.

Information relating to the two target businesses is as follows:

Assets

Land

Building

Equipment $($manufacturing$)$

Goodwill

License

$

$50,$ $

$000$

$300,000$

$500,000$

$-0$

$150,000$

$$1,000,00$

$0$

$2$

$40,000$

$310,000$

$200,000$

$450,000$

$-0-$

$$1,000,000$

Both target companies are manufacturers, though their products are different. Both are expected to generate annual profits of $$400,000$ before amortization$/$depreciation and income taxes.

One of the products of business $1$ is manufactured under license. The license agreement extends for $15$ years and stipulates payment of a royalty based on sales volume. The licensee has an option to renew the license at the end of the

$15-$year period subject to a renegotiation of the royalty percentage.

Currently, the cash reserves are invested in secure bonds, which earn interest at $12\%$ annually. These cash reserves are not sufficient to acquire both businesses, and so Patterson will acquire only one of them. The company intends to use the profits of the

acquired business to again build up a cash reserve, which will be invested in secure bonds. The corporate tax rate is $25\%.$

Required: Advise Patterson Traders whether it should purchase business $1$ or

business $2.$