The president of Plain Corp., Joyce Lima, is thinking of purchasing Balloon Bunch Corporation. She thinks that the offer sounds fair but she wants to consult a professional accountant to be sure. Balloon Bunch Corporation is asking for $85,000 in excess of the fair value of the identifiable net assets. Balloon Bunch's net income figures for the last five years are as follows:
2010 .......... $67,000
2011 .......... $50,000
2012 .......... $81,000
2013 .......... $80,000
2014 .......... $72,000
The company's identifiable net assets were appraised at $400,000 on December 31, 2014.
You have done some initial research on the balloon industry and discovered that the normal rate of return on identifiable net assets is 15%. After analyzing such variables as the stability of past earnings, the nature of the business, and general economic conditions, you have decided that the average excess earnings for the last five years should be capitalized at 20% and that the excess earnings will continue for about six more years. Further research led you to discover that the Happy Balloon Corporation, a competitor of similar size and profitability, was recently sold for $450,000, five times its average yearly earnings of $90,000.
Instructions
(a) Prepare a schedule that includes the calculation of Balloon Bunch Corporation’s goodwill and purchase price under at least three methods.
(b) Write a letter to Joyce Lima that includes all of the following:
1. An explanation of the nature of goodwill.
2. An explanation of the different acceptable methods of determining the fair value of goodwill. (Include with your explanation the rationale for how each method arrives at a goodwill value.)
3. Advice for Joyoe Lima on how to determine her purchase price.