Illustration 1: Applications of the Direct Valuation Method

ABC Co. is contemplating on acquiring XYZ, Inc. The following information was
gathered through a due diligence audit:

 The actual earnings of XYZ Inc. for the past 5 years are shown below:
Year Earnings
20x1 1,200,000
20x2 1,300,000
20x3 1,350,000
20x4 1,250,000
20x5 1,800,000
Total 6,900,000

 Earnings in 20x5 include an expropriation gain of 400,000.

 The fair value of XYZ’s net assets as of the end of 20x5 is 10,000,000,
 The industry average rate of return is 12%.
 Probable duration of “excess earnings” is 5 years.

Method 1: Multiples of average excess earnings

Under this method, goodwill is measured at the average excess earnings multiplied by
the probable duration of excess earnings.

Total earnings for the last 5 years 6,900,000

Less: Expropriation gain (400,000)
Normalized earnings for the last 5 years 6,500,000
Divide by: 5
(a) Average annual earnings 1,300,000

Fair Value of acquiree’s net assets 10,000,000

Multiply by: Normal rate of return 12%
(b) Normal earnings (1,200,000)

Excess earnings (a) – (b) 100,000

Multiply by: Probable duration of excess earnings 5
Goodwill 500,000

Method 2: Capitalization of average excess earnings

Under this method, goodwill is measured at the average excess earnings divided by a
pre-determined capitalization rate. (Assume a capitalization rate of 25%).

Average earnings [(6.9M-.4M expropriation gain)/5yrs.] 1,300,000

Normal earnings (10M x 12%) (1,200,000)
Excess earnings 100,000
Divide by: Capitalization rate 25%
Goodwill 400,000
Method 3: Capitalization rate of average earnings
Under this method, the average earnings are divided by a pre-determined capitalization
rate to estimate the purchase price of the business combination. The excess if the
estimated purchase price over the fair value of the acquiree’s net assets represents the
good will. (Assume a capitalization rate of 12.5%).

Average earnings [(6.9M-.4M expropriation gain)/5yrs.] 1,300,000

Divide by: Capitalization rate 12.5%
Estimates purchase price 10,400,000
Fair Value of XYZ’s net assets (10,000,000)
Goodwill 400,000

Method 4: Present value of average excess earnings

Under this method, goodwill is measured at the present value of average excess
earnings discounted at a pre-determined discount rate over the probable duration of
excess earnings. (Assume a discount rate of 10%).

Average earnings [(6.9M-.4M expropriation gain)/5yrs.] 1,300,000

Normal earnings (10M x 12%) (1,200,000)
Excess earnings 100,000
Multiply by: PV of an ordinary annuity @10%, n=5 3.79079
Goodwill 379,079
Illustration 2: Applications of the Direct valuation method
ABC Co. is estimating the goodwill in the expected purchase of XYZ, Inc. in January
20x6. The following information was determined.

Year Earnings Year-end net assets

20x1 120,000 480,000
20x2 130,000 580,000
20x3 135,000 540,000
20x4 125,000 560,000
20x5 140,000 590,000
Total 650,000 2,750,000

Case #1: Excess earnings

Goodwill shall be measured by capitalizing excess earnings at 30%, with normal return
on average net assets at 10%. The year-end net assets in 20x5 approximate fair value.

Requirement: Compute for the estimated purchase price in the contemplated business
combination.

Solution:
Average Earnings (650,000/5 years) 130,000
Normal Earnings on average net assets [10% x (2.75M/5)] (55,000)
Excess earnings 75,000
Divide by: Capitalization rate 30%
Goodwill 250,000
Add: Fair Value of net identifiable assets acquired 590,000
Estimated purchase price 840,000

Case #2: Average earnings

Goodwill shall be measured by capitalizing average earnings at 16%. The year-end net
assets in 20x5 approximate fair value.

Requirement: Compute for the estimated purchase price and goodwill in the
contemplated business combination.

Solution:
Average earnings (650,000/5 years) 130,000
Divide by: Capitalization rate 16%
Estimated purchase price 812,500
Fair value of net identifiable assets acquired (590,000)
Goodwill 222,500
Illustration 3: Applications of the Direct Valuation Method
ABC Co. plans to acquire the net assets of XYZ Inc. with carrying amount of 9,000,000.
This amount approximates fair value, except for one asset whose fair value exceeds its
carrying amount by 1,000,000. XYZ’s average earnings are 1,300,000. The industry
average rate return is 12% of the fair value of net assets. XYZ’s excess earnings are
expected to last for 5 years. The expected return on the investment is 10%.

Requirement: Compute for the estimated purchase price using the “present value of
average excess earnings” approach.

Solution:
Average earnings 1,300,000
Normal earnings in the industry (12% x 10M*) (1,200,000)
Excess earnings 100,000
Multiply by: PV of an ordinary annuity @10%, n=5 3.79079
Goodwill 379,079

*Carrying amount of equity 9,000,000

Excess of FV of one asset over its carrying amount 1,000,000
Fair value of XYZ’s net assets 10,000,000

Estimated purchase price (squeeze) 10,379,079

Less: Fair value of XYZ’s net assets (10,000,000)
Goodwill 379,079

Illustration 4: Applications of the Direct valuation method

ABC Co. acquired the net assets of XYZ, Inc. for 10,400,000. The acquisition resulted to
goodwill of 400,000 measured by capitalizing the annual superior earnings of XYZ at
25%. The normal rate of return is 12% on net assets before recognition of goodwill.

Requirement: Compute for the average earnings of XYZ.

Solution:
Average earnings (squeeze) 1,300,000
Normal Earnings (12% x 10M*) (1,200,000)
Excess earnings or superior earnings (given) 100,000
Divide by: Capitalization rate 25%
Goodwill (given) 400,000

*Purchase price (given) 10,400,000

Less: Fair value of net assets acquired (squeeze) (10,000,000)
Goodwill 400,000
Illustration 5: Applications of the Direct valuation method
ABC Co. and XYZ, Inc. decided to combine and set up a new entity – Alphabets
Corporation. The individual records of the combining constituents show the following:

ABC Co. XYZ, Inc.

Net assets (fair value) 400,000 600,000
Average annual earnings 80,000 120,000

Alphabets Corporation issues 10% preference shares with par value per share of 100
for the net assets contributions of the combining constituents and ordinary shares with
par value per share of 50 for the excess of total contributions (net asset contribution
plus goodwill) over net assets contributions.

The normal rate of return is 10% of net assets. Excess earnings will be capitalized at
20%.

Requirements: Compute for the following:

a. Goodwill
b. Total contributions of ABC Co. and XYZ, Inc.
c. The ratio of total shares (preference and ordinary) issued to ABC Co. and XYZ,
Inc.

Solutions:

Requirement (a):

ABC Co. XYZ, Inc. Total

Average annual earnings 80,000 120,000
Normal earnings on net assets (40,000) (60,000)
Excess earnings 40,000 60,000
Divide by: Capitalization rate 20% 20%
Goodwill 200,000 300,000 500,000

Requirement (b):
ABC Co. XYZ, Inc. Total
Total contribution (squeeze) 600,000 900,000 1,500,000
Fair value of net assets (400,000) (600,000)
Goodwill 200,000 300,000
Requirement (c):
ABC Co. XYZ, Inc. Total
Net asset contributions 400,000 600,000 1,000,000
Divide by: Par value per share of PS 100 100 100
Number of preference shares issued 4,000 6,000 10,000

Total contribution 600,000 900,000 1,500,000

Net asset contribution (400,000) (600,000) (1,000,000)
Excess of total contribution 200,000 300,000 500,000
Divide by: Par value per share of OS 50 50 50
Number of ordinary shares issued 4,000 6,000 10,000

Total PS and OS issued 8,000 12,000 20,000

Ratio of shares issued 40% 60% 100%

Illustration: Reverse acquisition

ABC Co., a publicly listed entity, and XYZ, Inc. an unlisted company, exchange equity
interests.
 ABC Co. issues 5 shares in exchange for all outstanding shares of XYZ, Inc.
 ABC’s shares are quoted at 40 per share, while XYZ’s shares have a fair value of
200 per share.
 The statements of financial position immediately before the combination are
shown below:

ABC Co. XYZ, Inc.

Identifiable assets 1,600,000 2,400,000
Total assets 1,600,000 2,400,000

Liabilities 1,3000,000 700,000

Share Capital:
10,000 ordinary shares, 10 par 100,000
8,000 ordinary shares, 100 par 800,000
Retained earnings 200,000 900,000
Total liabilities and equity 1,600,000 2,400,000

 The assets and liabilities approximate their fair values.

Requirements:
a. Identify the accounting acquirer
b. Compute for the goodwill

Solution:
Requirement (a):
Legal form of the contract: ABC issues 5 shares for each of the 8,000 outstanding
shares of XYZ. After the issuance, ABC’s equity will have the following structure:

ABC’s currently issued shares 10,000 20%

Shares issued to XYZ (5 x 8,000) 40,000 80%
Total shares after the combination 50,000

Analysis: The business combination is a reverse acquisition because XYZ obtains

control over ABC despite the fact that ABC is the issuer of shares. In other words, XYZ
let itself be acquired (legal form) in order to gain control over ABC (substance).

 XYZ, Inc., the legal acquiree, is the accounting acquirer.

 ABC, Co., the legal acquirer, is the accounting acquiree.

Requirement (b):
Substance of the contract: XYZ obtains control over ABS in a reverse acquisition.
Accordingly, the consideration transferred is computed based on the number of shares
XYZ (accounting acquirer) would have had to issue to give ABC (accounting acquire)
the same percentage of equity interest in the combined entity.

Reverse – XYZ (accounting acquirer) issues shares to ABC

Shares %
XYZ’s currently issued shares 8,000 80%
Shares issued to ABC [(8,000/80) x 20%] 2,000 20%
Total shares after the combination 10,000

If the business combination had taken the form of XYZ issuing additional ordinary
shares to ABC’s shareholders, XYZ would have had to issue 2,000 shares for the ratio
of ownership interest in the combined entity to be the same. XYZ’s shareholders would
then own 8,000 of the 10,000 issued shares of XYZ (80% of the combined entity), while
ABC’s shareholders own 2,000 (20% of the combined entity).

Consideration transferred (2,000 sh. x 200) 400,000

NCI -
PHE interest -
Total 400,000
Fair value of ABC’s net assets (1.6M – 1.3M) (300,000)
Goodwill 100,000
Problems:

Problem 1: FOR CLASSROOM DISCUSSION

Methods of estimating goodwill
Use the following information for the next four items:
Entity A is contemplating on acquiring Entity B.