FIN 620- Evaluation of potential acquisition

Please review my answers and calculations below to let me know if I am going in the right direction. Please comment on my reply to the questions and let me know if I am off base on the answers. Also, please assist/explain how to tackle the concept check.

Problem:

Evaluation of potential acquisition: Martin & Sons has $4.2 million in net working capital. The firm has total assets with a book value of $48.6 million and a market value of $53.4 million. They currently carry no debt on their balance sheet, sales are expected to be $45 million next year, and their tax rate is similar to ACME at 40%. Through a mixture of synergistic savings and increased market share this acquisition should add $2 million in net profit per year for the next 10 years. Acme Iron is considering buying the company for $60 million in cash. The acquisition will be recorded using the purchase accounting method.

What is the amount of goodwill that Acme will record on its balance sheet as a result of this acquisition?

Goodwill=purchase consideration- net assets

=60 million-53.4 milliom

=6.6 million

How do you recommend the firm finance this transaction? Is there a danger that ACME could damage their finances to the point that bankruptcy is a potential?

I recommend that the whole consideration not be paid in cash. We should either issue debt or equity for the same which reduces liquidity risk. This can be a great way to pursue an aggressive growth strategy, closely related is the advantage of paying off your debt in installments over a period of time. Relative to equity financing, you also benefit by not relinquishing any ownership or control of the business. Since you don't have to make debt payments, you can use the cash flow generated to further grow the company. There is a liquidity problem which could damage the company's finances with an end potential of bankruptcy.

Concept Check:

5-factor model of the Altman Z-score (a for private manufacturing firms):

Z-score = 0.717T₁ + 0.847T₂ + 3.107T₃ + 0.42T₄ + 0.998T₅

where,

T₁ = Working Capital / Total Assets T₂ = Retained Earnings / Total Assets T₃ = Earnings Before Interest and Taxes / Total Assets T₄= Equity / Total Liabilities T₅ = Sales / Total Assets

Zones of Discrimination:

• 23 or less – “Distress” Zone
• from 1.23 to 2.9 – “Grey” Zone
• 9 or more – “Safe” Zone

Interpretation of Altman Z-Score

The Z-Scores are helpful in predicting corporate defaults as well as an easy-to-calculate measure of control for financial distress status of companies in academic studies. A Z-Score above 2.6 (2.9) indicates a company to be healthy. Besides, such a company is also not likely to enter bankruptcy. However, Z-Scores ranging from 1.1-2.6 (1.23-2.9) are taken to lie in the grey area.