Impact on Future Profits and In-Process R&D The Mcquire Company is considering acquiring 100% of the Sosa Company. The management of Mcquire fears that the acquisition price may be too high. Condensed financial statements for Sosa Company for the current year are as follows: LO2 Income Statement 2008 Revenues $100,000 Cost of Goods Sold 40,000 Gross Margin 60,000 Operating Expenses 35,000 Pretax Income 25,000 Income Tax Expense 10,000 Net Income $ 15,000 Balance Sheet Year Ended 12/31/07 Year Ended 12/31/08 Cash $ 4,000 $ 4,000 Receivables 10,000 14,000 Inventory 31,000 27,000 Fixed Assets (net) 50,000 55,000 Total Assets $95,000 $100,000 Balance Sheet (continued) Year Ended 12/31/07 Year Ended 12/31/08 Current Liabilities $15,000 $ 17,000 Long-Term Liabilities 25,000 18,000 Common Stock 20,000 20,000 Retained Earnings 35,000 45,000 Total Liabilities and Equity $95,000 $100,000 You believe that Sosa might be currently acquired at a price resulting in a price to earnings (P/E) ratio of 8 to 12 times. Also, the fair market value of Sosa’s net assets is approximately $105,000, and the difference between fair value and book value is due solely to depreciable assets with a remaining useful life of 10 years. Sosa Company is heavily involved in research and development of new baseball bats that enable the batter to hit the ball further. You estimate that $30,000 of the acquisition price might be classified as in-process R&D and thus expensed in the year of acquisition. Sosa’s net income is expected to grow an average of 10%
per year for the next 10 years and remain constant thereafter.
Required:
A. If the acquisition occurs on January 1, 2009, determine the amount of income from Sosa Company that would be included in combined income assuming the following P/E ratios are used to determine the acquisition price, based on earnings for the year 2008.
(1) P/E ratio = 10 (2) P/E ratio = 12 B. If the FASB changes the current rules and requires that in-process R&D be capitalized and amortized over 20 years, how would this change your answer to part A?