Hardin Tool Company

Case: 12-1 Page: 354

Deal

Hardin Tool Company to acquire Pratt Engineering Company Pratt Engineering Companys management accepted the deal Exchange Hardin stock for Pratt stock Hardin to issue 100,000 shares for 40,000 shares of Pratt Hardins investment banks opinion: new public offering of 100,000 shares of Hardin can be made public at $8 per share

Financial Transactions
Income

statements reflect the best estimate of results of operations if the two firm were not to emerge but were to continue to operate as separate companies No inter company..,
Receivables Payables Sales Other

transactions

Financial Transactions
Appraised

value of Pratts net assets: $600,000 Pratts assets book value: $441,000 Alternative consummation..,
Package

consisting of 50,000 shares of Hardin common stock and $400,000 of either cumulative preferred stock with a 10% dividend or debentures with a 10% interest rates

C o n d e n se d Ba l a n c e S h e e t s a s o f t h e P ro p o se d A c q u isit ( T h o u sa n d s o f Do l l a rs) H a rd inP ra t t H a rd in P ra t t A sse t s C u r r e nt a sse t s $4 3 2 $2 4 6 39% 44% P la nt a nd e q u ip m e nt 690 31 2 61 % 56% T o t a l a sse t s $ 1 ,1 2 2 $ 5 5 8 1 0 0 % 1 0 0 % L ia b ilit ie s a nd E q u it ie s C u r r e nt liab ilit ie s $2 6 3 107 23% 1 9% L ong- t e r m d e b t 1 95 10 1 7% 2% C om m on st ock ($1 p a r ) 100 40 9% 7% A d d it iona l p aid - in cap it a l 21 8 94 1 9% 1 7% R e t a ine d e a r ning s 346 307 31% 55% T o t a l l ia b il it ie s a n d e q u it y $ 1 ,1 2 2 $ 5 5 8 1 0 0 % 1 0 0 %

C o n d e n se d Ba la n c e S h e e ts a s o f th e P ro p o se d ( T h o u sa n d s o f D o lla rs) H a r d i n r a t tH a r d i nP r a t t P S a le s $ 2 ,1 0 0 1 5 0 0 1 0 0 % 1 0 0 % E x penses 1620 1 120 77% 75% Incom e $480 $380 23% 25 % Incom e tax ex p e nse 168 133 8% 9% N e t in c o m e $31 2 $247 1 5 % 1 6%
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Discussion Question

Prepare consolidated balance sheets as of the proposed acquisition date, assuming the exchange of 10,000 shares of Hardin common stock on a purchase basis

Pooling vs. Purchase Method

C o n d e n se d B a la n c e S h e e ts a s o f th e P ro p o se d A c q u isit io n D a H a r d i nP r a t tP o o l i nP u r c h a s e g A ssets C urrent assets $43 2 $2 46 $678 $678 P la n t a n d e q u ip m e n t 690 3 1 2 $ 1 ,0 0 2 $ 1 ,1 6 11 0 0 2 + (6 0 0 -4 4 1 ) G o o d w ill 2 0 0(1 0 0 , 0 0 0 * 8 = 8 0 0 , 0 0 0 )-$ 6 T ota l a ssets $ 1 ,1 2 2 $ 5 5 8 $ 1 ,6 8 0 $ 2 ,0 3 9 L ia b ilit ie s a n d E q u it ie s C u r r e n t lia b ilit ie s $263 1 0 7 $3 70 $3 70 L ong- te rm d e b t 195 1 0 $20 5 $20 5 C om m on stock ($1 p a r ) 1 0 0 40 $20 0 $20 0 A d d it io n a l p a id - in c a p it a l 2 1 8 94 $2 5 2 $ 9 1 8p lu g in R e t a in e d e a r n in g s 346 30 7 $65 3 346 T o t a l l i a b i l i t i e s a n d $e1q,1 2 t2y $ 5 5 8 $ 1 ,6 8 0 $ 2 ,0 3 9 ui

Discussion Question

Assuming that in its first year of operations the combined company would achieve the same results of operations as the sum of the two firms independent operations What would be the combined companys net income and earnings per share on a pooling basis? Assume..,
Life of plant and equipment: 10 years Depreciation method: Straight line depreciation Income tax rate: 35%

C on d en sed In com e Sta tem en t a s of th e P rop o H a r d Pi n a P to l l i P u r c h a s e r t ng S a le s $ 2 ,1 0 0 5 0 0 3 ,6 0 0 $ 3 ,6 0 0 1 $ E x penses 1 6 2 01 1 2 0 2 ,7 4 0 $ 2 ,7 4 0 $ Incom e $ 4 8 0$ 3 8 0 $ 8 6 0 $ 8 6 0 A d d it io n a l d e p r e c ia t io n $ 1 6$ 1 5 9 , 0 0 0 / 1 0 y e a r s T a x a b le in c o m e $860 $844 Incom e tax ex p ense $ 3 0 1 .0 $ 2 9 5 . 4 N e t in c o m e $ 5 5 9 .0 $ 5 4 8 . 6 E a r n in g s P e r S h a r e $ 2 . 8 0 $ 2 .7 4
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Discussion Question
What

would be the combined net income and earnings per share under..,
Preferred

stock package Debenture package

Is

either of these proposals preferable to the all-common-stock proposal?

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E q u i t y S t o c k v s . P r e fe r r e d S t o c k v s . D e b e n t u r e s E q u i t y P r e fe r r eD e b e n t u r e s d U n a d ju s t e d in c om e $860 $860 $86 0 A d d it io n a l d e p r e c ia t io n 16 16 16 A d d it io n a l in t e r e s t 40 T a x a b le in c o m e $844 $844 $ 804 I ncom e tax e x p e nse $ 2 9 5 .4 0 $ 2 9 5 .4 0 $ 2 8 1 .4 0 N e t in c o m e $ 5 4 8 .6 0 $ 5 4 8 .6 0 $ 5 2 2 .6 0 P r e fe r r e d d iv id e n d $40 I n c o m e a v a ila b le t o c o m m on 5s 4 o c.6 0 $ 5 0 8 .6 0 $ 5 2 2 .6 0 $ t8 k E P S ( 1 5 0 ,0 0 0 s h a r e s fo r p r e fe r r e d P o o lin g o n a n d d e b e t n t u r e s a n d 2 0 0 ,0 0 0 E q u ity s h a r e s fo r e q u it y ) $ 2 .7 4 $ 3 .3 9 $ 3 .4 8 E x c h a n g e D e b t / e q u it y 1 4 .0 0 % 1 4 .0 0 % 5 6 .8 6 % 1 8 .5 5 % R O E (C om m on) 3 7 .5 0 % 4 7 .8 4 % 4 9 .1 5 % 5 0 .5 9 %

Discussion Question
Is

the investment banker the best judge of the worth $100,000 new shares of Hardins stock? Why not use a market price? If a market price is used, should it be the price as of the date of the handshake agreement, the signing of a formal agreement or the effective date of the agreement; or should it be some sort of average market price?
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Discussion Question
How

can an appraiser judge fair value of Pratts fixed assets? If appraiser is not the best judge, then who is? Should several independent appraisals be made?

14

Economic Values of Business Combinations

Economies

of scale Economies of scope Improved target management Tax benefits Availability of low cost financing for financially constrained targets

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Business Combination
Bringing

together of separate entities or businesses into one reporting entity Includes..,

Purchase

of all assets, liabilities and rights to the activities of an entity Purchase of some of assets, liabilities and rights to the activities of an entity that together meets the definition of a businesses Establishment of new legal entity in which assets, liabilities and activities of combined business will be held

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Business Combination
Payments

might be affected by..,

Payment

of cash Issuance of equity instruments Incurring of liabilities Sacrifice of other assets in exchange for acquisitions of business

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Exception to Business Combination

Joint

venture Businesses under common control Two or more mutual entities Separate entities brought together to form a reporting entity by contract alone without obtaining of an ownership interest

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Accounting Method
Pooling

of interest method

Eliminated

in US, Canada, Australia Combining financial statements after adjusting for mismatch in accounting methods

Acquisition
Blocks..,

method

Fair value of acquired assets Assumed liabilities Contingent liabilities

Greater

cost of implementation

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Identifying Acquirer

>1/2 voting rights in combined entity

Power to appoint or remove majority of BOM Power to cast majority of voting in meetings of BOD Ability to determine combine entities management team

Other factors..,
Fair value of companies Terms of arrangements Specific voting rights provided Other conditions Statutory requirements options or warrants on issue

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Cost of Business Combination

Aggregate

fair value of assets or equities given on the date of exchange + direct costs attributable to business combination Date of exchange: acquisition date Probable contingent may be included Cannot include expected losses after business combination
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Allocating the Cost of Business Combination

Identifiable Liabilities Contingent

assets

liabilities Good will = total net assets acquired cost of acquisition Variations between recognized values and fair values are not required to be recognized by acquiree
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Accounting for Amalgamation (AS) 14

Amalgamation
All

in the nature of merger

A&L of transferor company becomes A&L of transferee company Shareholders holding >90% of face value of shares of transferor company become shareholders of transferee company Consideration paid in equity shares + cash for fractional shares No adjustments intended to be made in book values of A&L Use: Pooling of interests method

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Accounting for Amalgamation (AS) 14

Amalgamation
May

in the nature of acquisition

not all of A&L of transferor company becomes A&L of transferee company Shareholders holding shares of transferor company do not hold bigger proportion of shares in amalgamated company Consideration paid = fair value of A&L market value of A&L Adjustments intended to be made in book values of A&L Use: purchase method

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Goodwill
Amortize

goodwill over a period not exceeding 5 years unless a longer period can be justified Factors considered in estimating life of goodwill..,
Foreseeable

life of business or industry Effects of product obsolescence and changes in demand Service life expectation of key employees Expected actions by competitors or potential competitors Legal, regulatory or contractual provisions affecting useful life

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Criteria for Pooling of Interest Accounting

Combining companies must be autonomous Combining companies must be independent Single transaction or transaction in one year Exchange of common stock not less than 90% No equity changes in contemplation No shares reacquired for purpose of combination No change in proportionate equity interest Voting rights immediately exercisable Combination resolved at consummation Combining may not agree to reacquire or retire any of the stock issued to effect the combination Combined company may not enter into any agreement for the benefit of former shareholders of the combining companies Combined company may not plan to dispose of substantial amounts of assets of the combining companies within two years of combination

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Business Combinations
Acquisition or purchase

Types of Business Combinations Uniting / Pooling of Interests Group Reorganization

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Intangible Assets

What is an intangible asset? Non monetary asset Without physical substance Controlled by the entity and held for use either in the production or supply of goods or services; or for rental to others; or for administration purposes

May be purchased or internally generated

When to initially recognize? future economic benefits attributable to the asset are probable the cost of the asset can be measured reliably Initial Measurement at Fair Value

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Intangible Assets Revaluation, Amortization and Impairment

Revaluation Amortization and Impairment

US GAAP / IFRS IFRS US GAAP / IGAAP Amortize if asset has a finite life If indefinite life, annual test for impairment Although allowed, but rare Not allowed No Presumed Maximum Life Reversal of Impairment Losses permitted in some circumstances in IFRS Not permitted in US GAAP

IGAAP

Rebuttable presumption 10 year life

of

If life exceeds 10 years, annual review for impairment

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Accounting Standards
India

AS 14 International accounting standard

IAS

22 business combination IAS 36 impairment of assets IAS 38 intangible assets FAS 141 Business combinations FAS 142 Goodwill and other intangible assets

International

IFRS 3

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Indication for Impairment Testing

External indication
Significant drop in market value of an asset Significant adverse change at firm level environments Change in market rates affecting recoverable value of an asset Carrying amount of net assets of the firm > market capitalization

Internal indication
Evidence of obsolescence or physical damage on net asset Change in firm operations Evidences from internal reporting for lower value of asset

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Measuring Recoverable Amount

RA is higher of..,
Net selling price Value in use

Requires cash flow forecast for atleast 5 years Estimated on present condition of the asset Cash flows and discount rate should be pre tax basis

No impairment required if either of above is more than carrying cost

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Impairment Test
Measuring

recoverable amount of an asset Impairment loss = assets carrying amount > recoverable amount Goodwill is allotted to cash-generating unit to assess recoverability

33

Reversal of Impairment Loss

Reversal

should be sustainable Allowed to the extent of carrying cost in the previous period On reversal requires correction in depreciation for earlier years

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Impairment Model

35

Assessment of Recoverable Amount

=

higher of {fair value less costs to sell and value in use}

Fair

value less costs to sell

Price agreed in a binding sales agreement for cashgenerating unit in an arms length transaction, adjusted for incremental costs attributable to the disposal Cannot be determined by reference to an active market

Value

in use

Present

value of estimated future cash flows Based on most recent financial budget / forecast approved by management

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Allocation of Goodwill to CashGenerating Units

Allocated

on the date of acquisition Based on relative value of cash-generating units Minority portion of the goodwill should be accounted for minority

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Impairment Test for Cash Generating Unit

To

be tested annually Difference can be tested at different time during the year Impairment test within cash generating unit must be tested for impairment before testing cash-generating as a whole Any impairment loss must be first applied against goodwill
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Accounting for Impairment Loss

Recognized

in P&L statement in the period in which it is identified First allocated to any recognized goodwill with in the cash-generating unit Additional losses treated as impairment of individual assets

39

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Impairment of Assets Differences

Difference Criterion Timing of impairment review IFRS and IGAAP Annually US GAAP whenever events or changes in circumstances indicate that the carrying amount may not be recoverable Fair value < Carrying amount Fair Value is the amount at which an asset or liability could be bought or settled in a current transaction between willing parties

Asset is Impaired if

Recoverable amount < Carrying amount

Recoverable Amount / Fair ValueRecoverable amount is higher of Net Selling Price Value in use Cash Flows for calculating value Use discounted cash flows in use / fair value for calculating the value in use Reversal of impairment loss

Use undiscounted cash flows for calculating the fair value

Whenever there is a change Prohibited in the economic conditions

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