EXERCISE 11–1 You are considering the purchase of all outstanding preferred and common stock of Finex, Inc., 

for $700,000 on January 2, Year 2. Finex’s financial statements for Year 1 are reproduced below.

FINEX, INC.

Balance Sheet As of December 31, Year 1 Cash................................................................................. $ 55,000 U.S. government bonds .................................................... 25,000 Accounts receivable, net .................................................. 150,000 Merchandise inventory ..................................................... 230,000 Land................................................................................. 40,000 Buildings, net(a)................................................................ 360,000 Equipment, net(b).............................................................. 130,000 Total assets...................................................................... $990,000 Accounts payable ............................................................. $170,000 Notes payable, current ..................................................... 50,000 Bonds payable, due Year 12

(c) .......................................... 200,000 Preferred stock, 6%, $100 par ......................................... 100,000 Common stock, $100 par ................................................. 400,000 Paid-in capital in excess of par........................................ 43,000 Retained earnings

(d) ......................................................... 27,000 Total liabilities and equity................................................ $990,000 Income Statement For Year Ended December 31, Year 1 Net sales .......................................................................... $860,000 Cost of good sold.............................................................. 546,000 Gross profit ...................................................................... 314,000 Selling and administrative expenses................................ 240,000 Net operating income ....................................................... 74,000 Income tax expense .......................................................... 34,000 Net income ....................................................................... $ 40,000

(a) Accumulated depreciation on buildings, $35,000.

Depreciation expense in Year 1, $7,900.

(b) Accumulated depreciation on equipment, $20,000.

Depreciation expense in Year 1, $9,000.

(c) Bonds are sold at par.

(d) Dividends paid in Year 1: preferred, $6,000;

common, $20,000.

You need to adjust net income to estimate the earnings potential of an acquisition. The company uses the FIFO method of inventory valuation and all inventories can be sold without loss. With the change in ownership you expect an additional 5% of net accounts receivable to be uncollectible.

You assume sales and all remaining financial relations are constant.

Required:

a. What reported value would be individually assigned to Land, Buildings, and Equipment after the proposed purchase assuming that we allocate the excess purchase price to these three assets in proportion to their respective book values on the Year 1 balance sheet? (implicitly assumes that these assets are undervalued by this amount)

b. Prepare a balance sheet for Finex, Inc., immediately after your proposed purchase.

c. Estimate Finex, Inc.’s net operating income for Year 2 under your ownership. (Hint: Use the same ratio of depreciation expense to assets; and one-third of depreciation is charged to cost of goods sold.)

d. Assuming your minimum required ratio of net operating income to net sales is 8%, should you purchase Finex, Inc.?