Question

Plantation Homes Company is considering the acquisition of Condominiums, Inc. early in 2015. To assess the amount it might be willing to pay, Plantation Homes makes the following computations and assumptions. 

A. Condominiums, Inc. has identifiable assets with a total fair value of $16,118,000 and liabilities of $9,099,000. The assets include office equipment with a fair value approximating book value, buildings with a fair value 29% higher than book value, and land with a fair value 74% higher than book value. The remaining lives of the assets are deemed to be approximately equal to those used by Condominiums, Inc. 

B. Condominiums, Inc.'s pretax incomes for the years 2012 through 2014 were $1,255,000, $1,559,000, and $1,006,000, respectively. Plantation Homes believes that an average of these earnings represents a fair estimate of annual earnings for the indefinite future. However, it may need to consider adjustments to the following items included in pretax earnings: 

 Depreciation on buildings (each year)

 909,000

 Depreciation on equipment (each year) 48,700

 Extraordinary loss (year 2014)

 300,000

 Sales commissions (each year)

 229,000

 C. The normal rate of return on net assets for the industry is 15%.

Assume further that Plantation Homes feels that it must earn a 25% return on its investment and that goodwill is determined by capitalizing excess earnings. Based on these assumptions, calculate a reasonable offering price for Condominiums, Inc. Indicate how much of the price consists of goodwill. Ignore tax effects. 

Goodwill _______ 

Offering prices _______ 

Answer 1

Solution

Plantation Homes Company

Calculation of a reasonable offering price for Condominiums Inc:

The normal rate of return on assets for similar firms in the industry is 15%.

Using the 15% rate of return to approximate normal earnings on net assets:

Fair Value of Assets	$16,118,000
Fair Value of Liabilities	$9,099,000
Fair Value of net assets	$7,019,000
Normal rate of return	15%
Normal earnings	$1,052,850

Estimation of the expected future earnings of Condominiums (excluding any nonrecurring gains or losses):

Pretax income of Condominiums Inc 2012	$1,255,000
Less: additional depreciation on buildings (909,000 x 29%)	$(263,610)
Adjusted net earnings 2012		$991,360
Pretax income of Condominiums Inc 2013	$1,559,000
Less: additional depreciation on buildings (909,000 x 29%)	$(263,610)
Adjusted net earnings 2013		$1,295,390
Pretax income of Condominiums 2014	$1,006,000
Add: Extraordinary Loss	$300,000
Less: additional depreciation on buildings (909,000 x 29%)	$(263,610)
Adjusted net earnings 20144		$1,042,390
Three-year total adjusted earnings		$3,329,140
Three-year average adjusted earnings		$1,109,713	(3,329,140/3)

Determination of excess earnings –

Expected target earnings        $1,109,713

Less: normal earnings            $1,052,850

Excess earnings per year        $56,863

Estimated goodwill from excess earnings:

Present value of excess earnings, (perpetuity at 25%)

Excess earnings/25% = 56,863/25% = $227,453

Estimated Goodwill = $227,453

Offering Price = estimated goodwill + fair value of firm’s net identifiable assets

= 227,453 + 7,019,000 = $7,246,453

Determination of implied offering price for an expected ROI 25%:

Excess earnings of Condominiums Inc          $56,863

PV factor, (P/A,25%, 3)                                 1.952

Estimated Goodwill                                        $110,997

Fair value of net assets                                   $7,019,000

Offering Price                                                 $7,129,997

Goodwill         $110,997

Offering Price $7,129,997