Estimated and Actual Goodwill

Passion Company is trying to decide whether or not to acquire Desiree Inc. The following balance sheet for Desiree Inc. provides information about book values. Estimated market values are also listed, based upon Passion Company”s appraisals.

Passion Company expects that Desiree will earn approximately $150,000 per year in net income over the next five years. This income is higher than the 12% annual return on tangible assets considered to be the industry “norm.”

Required:

1. Compute an estimation of goodwill based on the information above that Passion might be willing to pay (include in its purchase price), under each of the following additional assumptions:

(1) Passion is willing to pay for excess earnings for an expected life of five years (undiscounted).

(2) Passion is willing to pay for excess earnings for an expected life of five years, which should be capitalized at the industry normal rate of return.

(3) Excess earnings are expected to last indefinitely, but Passion demands a higher rate of return of 20% because of the risk involved.

1. Comment on the relative merits of the three alternatives in part (A) above.
2. Determine the amount of goodwill to be recorded on the books if Passion pays $800,000 cash and assumes Desiree”s liabilities.