Trans-Am Suppliers Ltd. is just completing negotiations to sell its manufacturing division to a competitor. The purchaser has agreed to purchase the inventory, manufacturing equipment, licence, and goodwill for $1,200,000.
The payment terms require that the purchaser pay $900,000 on the closing date, with the balance of $300,000 deferred for two years. The unpaid balance is subject to annual interest of 10%.Trans-Am intends to use the proceeds from the sale to expand its wholesale division, which is expected to generate returns of 24% annually before tax. The company’s tax rate is 25%.
Although the total price and payment terms have been agreed to, a conflict has arisen between Trans-Am and the purchaser regarding the price of each asset sold. The sources of the dispute are as follows:
• Inventory Trans-Am’s accounting records indicate that the inventory amounts to $300,000, valued at the lower of cost or market. Traditionally, the company has been conservative in establishing the market value. The purchaser, after examining the merchandise, feels that the proper value is $340,000 and expects that it could all be sold within one year.
• Equipment The manufacturing equipment, which originally cost $600,000, has a book value for accounting purposes of $300,000. The undepreciated capital cost is $320,000.Trans-Am has valued the equipment at $400,000, but the purchaser’s appraiser is confident that the equipment has a value of $450,000 in the used-equipment market.
• Licence One of Trans-Am’s products is manufactured under licence from a company that holds the patent. The licence, which has a life of 10 years, was purchased only six months earlier for $100,000. Shortly after the purchase, the product gained wide recognition; the company that holds the patent rights now sells licences in other geographic areas at a price of $300,000. Both Trans-Am and the purchaser agree on this value.
• Goodwill No discussion was held with respect to the goodwill, as both parties acknowledge that its value reflects the difference between the total purchase price of $1,200,000 and the combined values of the other specific assets.
The president of Trans-Am is concerned that the negotiation process will be stalled if the above issues are not settled. He is prepared to make some concessions but feels that before doing so, he must understand what the differences mean to Trans-Am. Also, the president thinks it would be useful to know the impact of his own stance on the purchaser, as this will suggest how rigid he should appear at the next round of discussions.
The president has asked you to report to him and provide the information requested. In addition, he has asked you to separately examine the tax implications of the deferred payment terms and determine whether the agreement should state the terms of payment for each asset as opposed to the total package.
Required: Prepare an outline of the report, including any necessary calculations.