Problem "Analyzing Pre- and Post-Acquisition Financial Statements"

You are considering the purchase of all outstanding preferred and common stock of Finex, Inc., for $700,000 on January 2, Year 2. Finex's financial statements for Year 1 are reproduced below:

FINEX, INC.

Balance Sheet

As of December 31, Year 1

Cash $55,000

U.S. government bonds25,000

Accounts receivable, net 150,000

Merchandise inventory 230,000

Land 40,000

Buildings, net(a) 360,000

Equipment, net(b) 130,000

Total assets $990,000

Accounts payable $ 170,000

Notes payable, current 50,000

Bonds payable, due Year 12(c) 200,000

Preferred stock, 6%, $100 par 100,000

Common stock, $100 par 400,000

Paid-in capital in excess of par 43,000

Retained earnings(d) 27,000

Total liabilities and equity $ 990,000

Income Statement

For Year Ended December 31, Year 1

Net sales $860,000

Cost of good sold 546,000

Gross profit 314,000

Selling and administrative expenses 240,000

Net operating income 74,000

Income tax expense 34,000

Net income $ 40,000

(a) Accumulated depreciation on buildings, $35,000. Depreciation expense in Year 1, $7,900.

(b) Accumulated depreciation on equipment, $20,000. Depreciation expense in Year 1, $9,000.

(c) Bonds are sold at par.

(d) Dividends paid in Year 1: preferred, $6,000; common, $20,000.

You need to adjust net income to estimate the earnings potential of an acquisition. The company uses the FIFO method of inventory valuation and all inventories can be sold without loss. With the change in ownership you expect an additional 5% of net accounts receivable to be uncollectible. You assume sales and all remaining financial relations are constant.

Required:

a.What reported value would be individually assigned to land, buildings, and equipment after the proposed purchase assuming that we allocate the excess purchase price to these three assets in proportion to their respective book values on the Year 1 balance sheet? (This implicitly assumes that these assets are undervalued by this amount.)

b.Arrange a balance sheet for Finex, Inc., immediately after your proposed purchase.

c.Estimate Finex, Inc.'s net operating income for Year 2 under your ownership. (Hint: Use the same ratio of depreciation expense to assets; and one-third of depreciation is charged to cost of goods sold.)

d.Assuming your minimum required ratio of net operating income to net sales is 8%, should you purchase Finex, Inc.?

CHECK (b) Total assets, $1,120,000 (c) Net operating income, $72,008

Note: This problem taken from The Book of Financial Statement Analysis by K. R Subramanyam Eleventh Edition Chapter 11 Equity Analysis and Valuation (Problem 11.2 Page 643-644).