5.

6efensive tactics include$ %1& (oison pill 7 when stock rights are issued to existing stockholders that enable them to purchase ANSWERS TO QUESTIONS additional shares at a price below market value, but exercisable only in the event of a potential takeover. *his tactic is effective in some cases. 1. Internal expansion involves a normal increase in business resulting from increased demand for %"& 8reenmail 7 when the shares held by a would4be acquiring firm are purchased at an amount products and services, achieved without acquisition of preexisting firms. Some companies expand substantially in excess of their fair value. *he shares are then usually held in treasury. *his tactic is internally by undertaking new product research to expand their total market, or by attempting to generally ineffective. obtain a greater share of a given market through advertising and other promotional activities. %'& 9hite knight or white squire 7 when a third firm more acceptable to the target company Marketing can also be expanded into new geographical areas. management is encouraged to acquire or merge with the target firm. xternal expansion bringing together two or an more firms under common control by %)& (ac4man defenseis7 the when the target firm of attempts unfriendly takeover of the would4be acquisition. !eferred to as business combinations, these combined operations may be integrated, or acquiring company. each firm be :ewels left to operate %1& Selling themay crown 7 when intact. the target firms sells valuable assets to others to make the firm less attractive to an acquirer. ". #our advantages of business combinations as compared to internal expansion are$ ;. In an asset acquisition, the firm must acquire operating 1<<= of the assets of the other firm, while in a stock %1& Management is provided with an established unit with its own experienced personnel, acquisition, a firmproductive may gain control byand purchasing 1<= or more of the voting stock. ,lso, in a stock regular suppliers, facilities distribution channels. formal negotiations the target>s management can sometimes be avoided. #urther, in %"& acquisition, xpanding by combination does with not create new competition. a stock acquisition, there might be advantages %'& (ermits rapid diversification into new markets.in keeping the firms as separate legal entities such as for tax purposes. %)& Income tax benefits. 1<. 6oes the merger or on decrease expected earnings of the acquiring institution? '. *he primary legalincrease constraint business combinations is performance that of possible antitrust suits. *he +nited #rom a financial and shar eholder perspective, theation priceof paid for a firm is hard :ustify if earnings per States government is opposed to the concentr economic power thatto may result from business share declines. 9hen thisenacted happens, thefederal acquisition is considered dilutive . -layton -onversely, if the earnings combinations and has two statutes, the Sherman ,ct and the ,ct to deal with per share increases as a result of the acquisition, it is referred to as an accretive acquisition. antitrust problems. 11. +nder the parent combination company concept, the writeup or writedown of same the net assets ofthat the subsidiary in ). %1& , hori.ontal involves companies within the industry have previously the consolidated financial statements is restricted to the amount by which the cost of the investment been competitors. is more combinations or less than the book value of the and net assets acquired. @oncontrolling %"& /ertical involve a company its suppliers and0or customers. interest in net assets is unaffected by such writeups or writedowns. %'& -onglomerate combinations involve companies in unrelated industries having little production *he economic unit concept supports the writeup or writedown of the net assets of the subsidiary by or market similarities. an amount equal to the entire difference between the fair value and the book value of the net assets on the date of acquisition. In this case, noncontrolling interest in consolidated net assets is ad:usted 1. , statutor y merger results when one company acquires all of the net assets of one or more other for its share of the writeup or writedown of the net assets of the subsidiar y. companies through an exchange of stock, payment of cash or property, or the issue of debt company remains as the only legal is entity, and the company 1". instruments. a& +nder the*he par acquiring ent company concept, noncontrolling interest considered a acquired liability of the ceases to exist or remains as a separate division of the acquiring company. consolidated entity whereas under the economic unit concept, noncontrolling inter est is considered a separate equity interest in consolidated net , statutory consolidation results when a new corporation isassets. formed to acquire two or more corporations, through an exchange of voting stock, with the acquired corporations ceasing to exist as b& *he legal parent company concept supports partial elimination of intercompany profit whereas the separate entities. economic unit concept supports 1<< percent elimination of intercompany profit. , stock acquisition occurs when one corporation issues stock or debt or pays cash for all or part of the voting of another company. stock may be acquired through market purchases through c& *hestock parent company concept *he supports valuation of subsidiary net assets in the or consolidated direct purchase from or exchange with individual stockholders investee subsidiar percentage y company. financial statements at book value plus an amount equal of tothe the parent or company>s interest in the difference between fair value and book value. *he economic unit concept 2. , tender offervaluation is an open offer to purchase up toin a the stated number offinancial shares ofstatements a given corporation at a supports of subsidiary net assets consolidated at their fair stipulated price share. *he offering price is generally set above the current marketownership price of the value on theper date of acquisition without regard to the parent company>s percentage shares to offer an additional incentive to the prospective sellers. interest. 3. , d& stock +nder exchange the parent ratio is company generallyconcept, expressed consolidated as the number net ofincome shares of measures the acquiring the interest company ofthat the shareholders of the ent company the operating results of the consolidated entity. +nder the are to be exchanged forpar each share of thein acquired company. 141 14"

CHAPTER 1

economic unit concept, consolidated net income measures the operating results of the consolidated entity which is then allocated between the controlling and noncontrolling interests. 1'. *he implied fair value based on the price may not be relevant or reliable since the price paid is a negotiated price which may be impacted by considerations other than or in addition to the fair value of the net assets of the acquired company. *here may be practical difficulties in determining the fair value of the consideration given and in allocating the total implied fair value to specific assets and liabilities. In the case of a less than wholly owned company, valuation of net assets at implied fair value violates the cost principle of conventional accounting and results in the reporting of subsidiary assets and liabilities using a different valuation procedure than that used to report the assets and liabilities of the parent company. 1). *he economic entity is more consistent with the principles addressed in the #,SA>s conceptual framework. It is an integral part of the #,SA>s conceptual framework and is named specifically in S#,- @o. 1 as one of the basic assumptions in accounting. *he economic entity assumption views economic activity as being related to a particular unit of accountability, and the standard indicates that a parent and its subsidiaries represent one economic entity even though they may include several legal entities. 11. *he #,SA>s conceptual framework provides the guidance for new standards. *he quality of comparability was very much at stake in #,SA>s decision in "<<1 to eliminate the pooling of interests method for business combinations. *his method was also argued to violate the historical cost principle as it essentially ignor ed the value of the consideration %stock& issued for the acquisition of another company. *he issue of consistency plays a role in the recent proposal to shift from the parent concept to the economic entity concept, as the former method valued a portion %the noncontrolling interest& of a given asset at prior book values and another portion %the controlling interest& of that same asset at exchange4date market value. 12. -omprehensive income is a broader concept, and it includes some gains and losses explicitly stated by #,SA to bypass earnings. *he examples of such gains that bypass earnings are some changes in market values of investments, some foreign currency translation ad:ustments and certain gains and losses, related to minimum pension liability. In the absence of gains or losses designated to bypass earnings, earnings and comprehensive income are the same.

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ANSWERS TO BUSINESS ETHICS CASE 1. *he third item will lead to the reduction of net income of the acquired company before acquisition, and will increase the reported net income of the combined company subsequent to acquisition. *he accelerated payment of liabilities should not have an effect on net income in current or future years, nor should the delaying of the collection of revenues %assuming those revenues have already been recorded&. ". *he first two items will decrease cash from operations prior to acquisition and will increase cash from operations subsequent to acquisition. *he third item will not affect cash from operations. '. ,s the manager of the acquired company I would want to make it clear that my future performance %if I stay on with the consolidated company& should not be evaluated based upon a future decline that is perceived rather than real. #urther, I would express a concern that shareholders and other users might view such accounting maneuvers as sketchy. ). a& arnings manipulation may be regarded as unethical behavior regardless of which side of the acquirer0acquiree equation you>re on. *he benefits that you stand to reap may differ, and thus your potential liability may var y. Aut the ethics are essentially the same. +ltimately the company may be one unified whole as well, and the users that are affected by any kind of distorted information may view any participant in an unsavor y light.

b& See answer to %a&.

14)

ANSWERS TO EXERCISES Exercise 1-1 Part A @ormal earnings for similar firms B %C11,<<<,<<< 4 C5,5<<,<<<& x 11= B C;'<,<<< xpected earnings of target$ (retax income of -ondominiums, Inc., "<<5 C1,"<<,<<< Subtract$ ,dditional depr eciation on building %C;2<,<<< *arget>s ad:usted earnings, "<<5 (retax income of -ondominiums, Inc., "<<; C1,1<<,<<< Subtract$ ,dditional depreciation on building %"55,<<<& *arget>s ad:usted earnings, "<<; (retax income of -ondominiums, Inc., "<1< C;1<,<<< ,dd$ xtraordinary loss Subtract$ ,dditional depreciation on building %"55,<<<& *arget>s ad:usted earnings, "<1< *arget>s three year total ad:usted earnings ',<52,<<< *arget>s three year average ad:usted earnings %C',<52,<<< '& '<=& %"55,<<<& ;1",<<<

1,"1",<<< '<<,<<< ;2",<<< 1,<"5,223

xcess earnings of target B C1,<"5,223 4 C;'<,<<< B C;5,223 per year (resent value of excess earnings %perpetuity& at "1=$ B C';),225 % stimated 8oodwill&
"1 % $ ;5 ,223

Implied offering price B C11,<<<,<<< 7 C5,5<<,<<< D C';),225 B C2,1;),225. Part B xcess earnings of target %same as in (art ,& B C;5,223 (resent value of excess earnings %ordinar y annuity& for three years at 11=$ C;5,223 "."5'"' B C""1,"3; Implied offering price B C11,<<<,<<< 7 C5,5<<,<<< D C""1,"3; B C2,)"1,"3;. @ote$ *he sales commissions and depreciation on equipment are expected to continue at the same rate, and thus do not necessitate ad:ustments.

141

Exercise 1-2 Part A -umulative 1 years net cash earnings ,dd nonrecurring losses Subtract extraordinary gains #ive4years ad:usted cash earnings ,verage annual ad:usted cash earnings C51<,<<< )5,<<< %23,<<<& C5'1,<<< C122,"<<

$ 5'1 ,<<< 1

%a& stimated purchase price B present value of ordinar y annuity of C122,"<< %nB1, rateB 11=& C122,"<< '.'1"12 B C113,1"; %b& Eess$ Market value of identifiable assets of Aeta Eess$ Eiabilities of Aeta Market value of net identifiable assets Implied value of goodwill of Aeta Part B ,ctual purchase price Market value of identifiable net assets 8oodwill purchased C31<,<<< '"<,<<< )'<,<<< C1"3,1"; C2"1,<<< )'<,<<< C1;1,<<<

Exercise 1-3 Part A @ormal earnings for similar firms %based on tangible assets only& B C1,<<<,<<< x 1"= B C1"<,<<< xcess earnings B C11<,<<< 7 C1"<,<<< B C'<,<<< %1& 8oodwill based on five years excess earnings undiscounted. 8oodwill B %C'<,<<<&%1 years& B C11<,<<< %"& 8oodwill based on five years discounted excess earnings 8oodwill B %C'<,<<<&%'.2<)5& B C1<5,1)) %present value of an annuity factor for nB1, IB1"= is '.2<)5& %'& 8oodwill based on a perpetuity 8oodwill B %C'<,<<<&0."< B C11<,<<< Part B *he second alternative is the strongest theoretically if five years is a reasonable representation of the excess earnings duration. It considers the time value of money and assigns a finite life. ,lternative three also considers the time value of money but fails to assess a duration period for the excess earnings. ,lternative one fails to account for the time value of money. Interestingly, alternatives one and three yield the same goodwill estimation and it might be noted that the assumption of an infinite life is not as absurd as it might sound since the present value becomes quite small beyond some hori.on. Part C 8oodwill B F-ost less %fair value of assets less the fair value of liabilities&G, 142

Hr, -ost less fair value of net assets 8oodwill B %C5<<,<<< 7 %C1,<<<,<<< 4 C)<<,<<<&& B C"<<,<<<

143