Macho Inc. has recently become interested in acquiring a South American plant to handle many of its production functions in that market. One possible candidate is De Fuentes SA, a closely held corporation, whose owners have decided to sell their business if a proper settlement can be obtained. De Fuentes's statement of financial position is as follows:

Current assets

$12,500,000

Fair value - net income investments

5,500,000

Buildings (net)

4,050,000

Total assets

$22,050,000

Current liabilities

$ 8,500,000

Notes payable

9,500,000

Share capital

2,350,000

Retained earnings

1,700,000

Total Liabilities and Equities

$22.050,000

Macho has hired Yardon Appraisal Corporation to determine the proper price to pay for De Fuentes SA. The appraisal firm finds that the fair value - net income investments have a fair value of $7,500,000 and that inventory is understated by $4,000,000. All other assets and liabilities have book values that approximate their fair values.

An examination of the company's income for the last four years indicates that the net income has steadily increased. In 2018, the company had a net operating income of $1,100,000, and this income should increase each year over year by:

10% 2019

12% 2020

8% 2021

7 % 2022

While Macho does not have a normal return in this type of business, the company was attempting to select an appropriate capitalization rate for Valuing a private business and was considering various rates. These included the Long-term Canadian Bond rate was around 3.5-4%, that the average premium on return on small co shares over government bonds were 7%, that there was another premium for greater risk and illiquidity for 8 % and the consensus for long term inflation expectations were based on the approximate average of past 20-25 years of the CPI (although the Gross National Implicit Price Deflator Index was a better Index base to predict Inflation).

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The asset investment in the South American plant is expected to stay the same for the next four years.

Instructions:

(a)Yardon Appraisal Corporation has indicated that the company's fair value can be estimated in several ways. Prepare estimates of the value of De Fuentes SA, with the value based on each of the following independent assumptions:

1.Goodwill is based on the purchase of average excess earnings over the next four years.

2.Goodwill is equal to the capitalization of average excess earnings of De Fuentes SA at 30%.

3.Goodwill is equal to the present value of the average excess earnings over the next four years discounted at 15%.

4.The value of the business is based on the capitalization of future excess earnings of De Fuentes SA at 16%.

(b) De Fuentes SA is willing to sell the business for $10 million. What advice should Yardon Appraisal give Macho in regard to this offer?

(c)If Macho were to pay $8,500,000 to purchase the assets and assume the liabilities of De Fuentes SA, how would this transaction be reflected on