Question

ESSAY QUESTION.

Rancho 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 DAL SA, a closely held corporation, whose owners have decided to sell their business if a proper settlement can be obtained. DAL’s statement of financial position is as follows:

Current assets			$	125,000
Fair value-net income investments				55,000
Plant assets (net)				405,000
Total assets			$	585,000
Current liabilities			$	85,000
Long-term debt				105,000
Share capital				225,000
Retained earnings				170,000
Total equities			$	$585,000

Rancho has hired Paribus Appraisal Corporation to determine the proper price to pay for DAL 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 2017, the company had a net operating income of $110,000, and this income should increase by 15% each year over the next four years. Rancho 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.

(b) DAL SA is willing to sell the business for $1 million. What advice should Paribus Appraisal give Rancho in regard to this offer?

Answer 1

	Calculation of net assets value of DAL SA
	Particular			Amount ($)
	Current assets (W. N.1)			165,000
	Fair value-net income investments			75,000
	Plant assets (net)			405,000
	Total assets	(A)		645,000
	Current liabilities			85,000
	Long-term debt			105,000
	Total outside liab. (B)			190,000
	Net assets (A)-(B)			455,000
Working Note: -
(1)	Particlars		Amount
	Current Assets		125,000
Add: -	understated inventory		40,000
	Total		165,000
	As given in the questionIn 2017, the company had a net operating income of $110,000 and
	this income should increase by 15% each year over the next four year and Rancho believes
	that a normal return in this type of business is 15% on net assets so normal return
	is 455000*15%	=	68,250
	expected Earning effect		126,500	For 1st year end
	Excess		58,250
	Rancho also have expected return of 15% and there is an increse of 15% p.a in expected
	earning so Rancho will also pay extra consideration for excess profit i.e.
	58250/15%	=	388,333.33
	Maximum amount to be paid by Rancho to DAL SA is
	Particular		Amount ($)
	Net assets		455,000.00
	For extra earning		388,333.33
	Total		843,333.33
	if DAL SA is willing to sell the business for $1 million then Paribus Appraisal should give
	advice Rancho is not to accept this offer