Question

Parent Inc. is contemplating a tender offer to acquire 80% of Subsidiary Corporation's common stock. Subsidiary's shares are currently quoted on the New York Stock Exchange at $85 per share. In order to have a reasonable chance of the tender offer attracting 80% of Subsidiary's stock, Parent believes it will have to offer at least $105 per share. If the tender offer is made and is successful, the purchase will be consummated on January 1, 2017.

A typical part of the planning of a proposed business combination is the preparation of projected or pro forma consolidated financial statements. As a member of Parent's accounting group, you have been asked to prepare the pro forma 2017 consolidated financial statements for Parent and Subsidiary assuming that 80% of Subsidiary's stock is acquired at a price of $105 per share. To support your computations, Martha Franklin, the chairperson of Parent's acquisitions committee, has provided you with the projected 2017 financial statements for Subsidiary. (The projected financial statements for Subsidiary and several other companies were prepared earlier for the acquisition committee's use in targeting a company for acquisition.) The projected financial statements for Subsidiary for 2017 and Parent's actual 2016 financial statements are presented in Table 1.

Answer 1

Answer:

Assumption

Ms. Franklin has asked you to use the assumptions below to project Parent's 2013 financial statements.

1. Sales will increase by 10% in 2017.
2. All sales will be on account.
3. Accounts receivable will be 5% lower on December 31, 2017, than on December 31, 2016.
4. Cost of goods sold will increase by 9% in 2017.
5. All purchases of merchandise will be on account.
6. Accounts payable are expected to be $50,500 on December 31, 2017.
7. Inventory will be 3% higher on December 31, 2017, than on December 31, 2017.
8. Straight-line depreciation is used for all fixed assets.
9. No fixed assets will be disposed of during 2017. The annual depreciation on existing assets is $40,000 per year.
10. Equipment will be purchased on January 1, 2017, for $48,000 cash. The equipment will have an estimated life of 10 years, with no salvage value.
11. Operating expenses, other than depreciation, will increase by 14% in 2017.
12. All operating expenses, other than depreciation, will be paid in cash.
13. Parent's income tax rate is 40%, and taxes are paid in cash in four equal payments. Payments will be made on the 15th of April, June, September, and December. For simplicity, assume taxable income equals financial reporting income before taxes.
14. Parent will continue the $2.50 per share annual cash dividend on its common stock.
15. If the tender offer is successful, Parent will finance the acquisition by issuing $170,000 of 6% nonconvertible bonds at par on January 1, 2017. The bonds would first pay interest on July 1, 2017, and would pay interest semiannually thereafter each January 1 and July 1 until maturity on January 1, 2027.
16. The acquisition will be accounted for as a purchase and Parent will account for the investment using the equity method. Although most of the legal work related to the acquisition will be handled by Parent's staff attorney, direct costs to prepare and process the tender offer will total $2,000 and will be paid in cash by Parent in 2017.

As of January 1, 2017, all of Subsidiary's assets and liabilities are fairly valued except for machinery with a book value of $8,000, an estimated fair value of $9,500, and a 5-year remaining useful life. Assume that straight-line depreciation is used to amortize any revaluation increment.

No transactions between these companies occurred prior to 2017. Regardless of whether they combine, Parent plans to buy $50,000 of merchandise from Subsidiary in 2017 and will have $3,600 of these purchases remaining in inventory on December 31, 2017. In addition, Subsidiary is expected to buy $2,400 of merchandise from Parent in 2013 and to have $495 of these purchases in inventory on December 31, 2017. Parent and Subsidiary price their products to yield a 65% and 80% markup on cost, respectively.

Parent intends to use three financial yardsticks to determine the financial attractiveness of the combination. First, Parent wishes to acquire Subsidiary Corporation only if 2017 consolidated earnings per share will be at least as high as the earnings per share Parent would report if no combination takes place. Second, Parent will consider the proposed combination unattractive if it will cause the consolidated current ratio to fall below two to one. Third, return on average stockholders' equity must remain above 20% for the combined entity.

If the financial yardsticks described above and the nonfinancial aspects of the combination are appealing, then the tender offer will be made. On the other hand, if these objectives are not met, the acquisition will either be restructured or abandoned.

Table 1

Parent Inc. Actual Financial Statements for 2016 and

Subsidiary Corporation Projected Financial Statements for 2017

	Parent 2016 Actual	Subsidiary 2017 Projected
Sales	$800,000	$100,000
Cost of goods sold	(485,000)	(55,000)
Operating expenses	(219,000)	(10,000)
Income before taxes	96,000	35,000
Income tax expense	(38,400)	(14,000)
Net income	57,600	21,000
Retained earnings, January 1	23,000	14,500
Add; net income	57,600	21,000
Less: dividends	(38,000)	(7,000)
Retained earnings, December 31	42,600	28,500
Cash	36,200	19,500
Accounts receivable	39,000	13,000
Inventory	26,000	12,000
Property, plant, and equipment	673,000	213,000
Accumulated depreciation	(490,000)	(28,000)
Total assets	284,200	229,500

	Parent 2016 Actual	Subsidiary 2017 Projected
Accounts payable	44,600	21,000
Common stock *	190,000	150,000
Paid-in capital in excess of par	7,000	30,000
Retained earnings	42,600	28,500
Total liabilities and stockholders' equity	284,200	229,500
* Parent: $12.50 par; Subsidiary: $75 par