I thought this was a good question and I wanted to share… Co. A acquired Co. B at the beginning of this year by exchanging newly issued stock. At the acquisition date, Co. B had bonds outstanding with a FV of $75M. The carrying value of the bonds was $82M. The fair values of Maverick’s remaining assets and liabilities were equal to book value. As compared to the pooling method, what is the impact on Mustang’s profitability and leverage at year end? Profitability/Leverage A. Lower/Lower B. Lower/Higher C. Higher/Lower D. Higher/Higher
A
Aladak - Wow. That was fast. It took me longer to type it than for you to answer it. I guess the question is more obvious than I thought. You’re correct.
note to self purchase mehod resuls in less profitability and less leverage
aladak Wrote: ------------------------------------------------------- > A why profitability is lower?
purchase results in goodwill which needs to be tested annually for impairment
profitability is lower with purchase because you are re instating assets at fair value thus will result in higher depn… Inventory is restated as well so higher cost of goods sold lower income… I am not sure about the leverage ratio? are we taking it assets D/A because Debt would increase under purchase and Assets as well so what is hte impact?
also the additional depreciation from the purchase method will lower NI
how did you come up with the leverage as lower please?
wonder2008 Wrote: ------------------------------------------------------- > profitability is lower with purchase because you > are re instating assets at fair value thus will > result in higher depn… Inventory is restated > as well so higher cost of goods sold lower > income… > > I am not sure about the leverage ratio? are we > taking it assets D/A because Debt would increase > under purchase and Assets as well so what is hte > impact? In this case it won’t apply as the assets fair value = book value. I guest asset impairment test is the answer but the profitability will be low only if it gets impaired which won’t happen every year.
wonder2008 Wrote: ------------------------------------------------------- > how did you come up with the leverage as lower > please? leverage lower because fair value of debt is lower than book value of debt and the equity issued for payment of transaction will also be more in case of purchase method. nova_cfa, can we have the explanation for this?
ok hold on just a minute… there is additional depreciation when you mark UP your assets - this questions says, besides the fair value of the debt being different all other remaining assets and liabilities book value and fair value is equal… so how the heck does profitability get affected here?? - not via higher depreciation
Full answer: Since the book value of the bond liability exceeded the fair value, a bond discount is created at the acquisition date. Amortizing the discount would increase interest expense and thus lower profitability. Recording the bond at the lower fair value reduces debt. Also, increasing the equity by the fair value of the shares issued increases equity. Lower debt and higher equity lowers leverage.
I think I’m missing something here. the question said the BV of assets was = fair market value, so there is no higher depreciation to lower profitability, right? The only difference in the purchase is that the liability will be lower. That will certainly result in a lower leverage ratio, but where is the extra charge to income coming from?
^^ oops…kabhii beat me to it… but I totally agree with him…
good question but in general, for purchase, NI is lower
aladak - i suggest you don’t go by that general rule - you’ll need the specifics of the transation…and we all know how cfai loves to test these kinda things… just my $.02
depends on the profitability of the aquired company the interest expense is just an element
wait At the acquisition date, Co. B had bonds outstanding with a FV of $75M. The carrying value of the bonds was $82M. The fair values of Maverick’s remaining assets and liabilities were equal to book value. where did u get that the BV of the bonds is higher than fair value?
I think carrying value of bond is the book value and FV represents the fair value.