CHAPTER 2
Initial Measurement of Acquired Intangible Assets

A. Overview of Fair Value Measurement as Applicable to Intangible Assets

The principles used for determining the fair value of intangible assets (as well as many other assets) are found in ASC 820 and in IFRS 13, Fair Value Measurement. These two sets of rules are substantially identical, so although the following discussion is in the context of ASC 820, it applies equally to IFRS 13.

ASC 820 identifies several valuation techniques and requires an entity to select the techniques most appropriate for the circumstances and for which there is sufficient data available for the measurement. The three widely used valuation approaches (under which there are various valuation techniques) are the cost approach, the market approach, and the income approach.1

All valuation approaches require data (called inputs), such as the quoted price of stock on an exchange or the estimated cash flows from an asset. Inputs used to determine fair values are either derived from market observations or developed internally. If there is an observable market for an asset, there typically will be either a quoted price for the asset or similar asset or a past transaction regarding the asset or similar asset. As an example, the fair value of real estate can be estimated from sales of similar property. However, market observations can take other forms also, such as the royalty rates the market charges to license similar assets. Identifying sufficient data when determining the fair values of intangible assets can be difficult because there often is not an observable market for them. However, even if there is not an observable market, there is likely some market observation that can be used as a foundation for developing the value of an intangible asset.

B. Valuation Techniques and Inputs Relevant to Intangible Assets

1. Inputs to Valuing Intangible Assets

ASC 820 states that inputs for estimating fair value may be either observable or unobservable. Specifically, observable inputs are developed using market data and reflect the assumptions market participants would use in pricing the asset or liability.3 The Codification provides examples of markets in which inputs might be observable for some assets and liabilities (e.g., financial instruments). These include the following:

  1. Exchange market. In an active exchange market, closing prices are both readily available and generally representative of fair value. An example of such a market is the New York Stock Exchange.
  2. Dealer market. In a dealer market, dealers stand ready to trade (either buy or sell for their own account), thereby providing liquidity by using their capital to hold an inventory of the items for which they make a market. Typically, bid and ask prices (representing the price the dealer is willing to pay and the price at which the dealer is willing to sell, respectively) are more readily available than closing prices. Over-the-counter markets (where prices are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by Pink Sheets LLC) are dealer markets. For example, the market for U.S. Treasury securities is a dealer market. Dealer markets also exist for some other assets and liabilities, including other financial instruments, commodities, and physical assets (for example, certain used equipment).
  3. Brokered market. In a brokered market, brokers attempt to match buyers with sellers but do not stand ready to trade for their own account. In other words, brokers do not use their own capital to hold an inventory of the items for which they make a market. The broker knows the prices bid and asked by the respective parties, but each party is typically unaware of another party's price requirements. Prices of completed transactions are sometimes available. Brokered markets include electronic communication networks, in which buy and sell orders are matched, and commercial and residential real estate markets.
  4. Principal-to-principal market. Principal-to-principal transactions, both originations and resales, are negotiated independently with no intermediary. Little information about those transactions may be released publicly.4

Unobservable inputs are inputs for which market data are not available. They are developed internally using the best information available about the assumptions that market participants would use when pricing an asset or liability.5 Unobservable inputs are used only when relevant observable inputs are unavailable. Thus, they are used in situations in which there is little, if any, market activity for an asset or liability.6 Typically, an entity will develop or identify data and then adjust the data if reasonably available information indicates that other market participants would use different data. However, an entity also tailors its data to its unique circumstances. So if there is something particular to an entity that is not available to other market participants, the entity's data must reflect this unique position even though market participants would not consider such circumstances.7 For example, in valuing intangible assets related to its supply chain, a company like Wal-Mart might use data that reflects the unique efficiencies and economies of scale of its supply chain management system.

To increase consistency and comparability in fair value measurements and related disclosures, the FASB developed a fair value hierarchy to prioritize the inputs to valuation techniques used to measure fair value. The fair value hierarchy consists of three broad levels. The highest priority is given to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1), and the lowest priority to unobservable inputs (Level 3), with quoted prices (adjusted) in active markets for similar assets or liabilities (Level 2) falling in the middle. In some cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls should be determined based on the lowest-level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability.

The availability of inputs relevant to the asset or liability and the relative reliability of the inputs might affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques. For example, a fair value measurement using a present value technique might fall within Level 2 or Level 3, depending on the inputs that are significant to the measurement in its entirety and on the level in the fair value hierarchy within which the significant inputs fall.8

2. Valuation Approaches and Techniques

a. Generally

In many instances, the fair value of an intangible asset can be measured by referring to some observable market-based source, especially if the intangible asset fits both the contract/legal criterion and the separability criterion. Specifically, it is possible that an intangible asset is similar to other intangible assets with an observable market.

Intangible assets without an observable market are usually measured through the use of a method under the income approach if cash flows resulting from the specific intangible asset can be reliably measured. Alternatively, assets that are more of a contributory nature might be measured based on the cost of replacing their utility.

Valuation techniques commonly used to determine the fair value of intangible assets are discussed ahead and illustrated in Section 2.C.

b. Common Valuation Techniques for Measuring the Fair Value of Intangible Assets

ASC 820-10 describes three basic approaches used to measure fair value: the income approach, the market approach, and the cost approach. Each approach has various valuation techniques (i.e., methods) that are available to determine the fair value of intangible assets.

(1) Income Approach

The income approach is commonly used to measure the fair value of a recognized intangible asset.9 It encompasses valuation techniques that convert future amounts (typically cash flows or earnings) to a discounted present value amount. The most common valuation techniques under the income approach are present value techniques; option-pricing models (such as the Black-Scholes-Merton Formula (a closed-form model) and a binomial model (i.e., a lattice model)); and the multi-period excess earnings method, which is used to measure the fair value of some intangible assets.10

The common methods to measure the fair value under the income approach are the discounted cash flow method, the multi-period excess earnings method, the scenario method, and the greenfield method.

A. Discounted Cash Flow    One of the most common methods under the income approach for measuring fair value is the discounted cash flow method (DCF). The DCF is often used to measure the fair value of the entire entity acquired as part of a business combination. Variations of the DCF can also be used to measure the fair value of an individual intangible asset. While there are other valuation methods under the income approach, these methods are often derived from the fundamental DCF method.

The DCF is defined in the International Glossary of Business Valuation Terms as β€œthe present value of future expected net cash flows calculated using a discount rate.”

The present value formula for the discounted cash flow analysis using a midyear convention is:

images

The DCF method of estimating fair value requires three basic inputs: (1) the expected cash flows to be received over the explicit forecast period, (2) the terminal value or perpetuity value that captures the value after the explicit forecast period, and (3) the discount rate, adjusted for the risk of actually receiving the cash flows. The exponents 0.5, 1.5, through n – 0.5 are the number of years using a midyear convention assuming that cash flows are received evenly over the year.

B. Multi-period Excess Earnings Method    The multi-period excess earning method (MPEEM) is a variation of the discounted cash flow analysis that is often used to measure the fair value of the primary intangible asset acquired as part of a business combination. Unlike the DCF, which measures fair value by discounting cash flows for an entire entity, the MPEEM measures fair value by discounting expected future cash flows attributable to a single intangible asset. Typically, this method is appropriate when the single asset is the primary generator of cash flows for the entity. Customer relationships and technology are examples of intangible assets that are primary generators of cash flows and are therefore suitable for fair value measurement using the MPEEM.

To isolate cash flows attributable to a specific intangible asset, the portion of cash flows attributed to all other assets is deducted from total entity cash flows. The deduction of cash flows attributable to all other assets is accomplished through a contributory asset charge (CAC). The CAC is an economic charge for the use of all other assets in generating total cash flows.

The CAC is the required rate of return for use of all of the other assets of the entity except for the primary asset, including an amount necessary to replace the fair value of the contributory intangible assets. The amount necessary to replace the fair value of other contributory tangible assets is generally already taken into consideration in the total entity cash flows. The β€œreturn on” and β€œreturn of” concepts imbedded in contributory charges are similar to that for investment analysis. The Appraisal Foundation issued The Identification of Contributory Assets and Calculation of Economic Rents as part of a series entitled Best Practices for Valuations in Financial Reporting: Intangible Asset Working Group (Contributory Assets). The Appraisal Foundation's Contributory Assets is the most comprehensive guidance within the valuation profession about contributory charges under the MPEEM.

The MPEEM is illustrated in Section 2.C.3.c.

C. Scenario Method (Incremental Income/Deficit)    The scenario method, sometimes referred to as the income increment/cost decrement method, is a method under the income approach that identifies incremental cash flows attributable to the subject intangible asset. The method simply measures the discounted estimated incremental cash flows that will result from the use of the asset over its estimated remaining useful life. The incremental cash flows may result from incremental revenue that the asset provides, or the incremental cash flows may result from a cost saving from the use of the asset. The method compares the cash flows resulting from two scenarios: one scenario assumes the asset is in place and is utilized by the entity and the second scenario assumes the asset is not being use by the entity. The fair value of the intangible asset is measured by the difference in the present value of cash flows from the two scenarios. The method is most often used to measure the fair value of intangible assets of a contributory nature, such as non-compete agreements.

The scenario method is illustrated in Section 2.C.3.f.

D. Greenfield Method    It may be difficult to measure the fair value intangible assets like licenses or permits to operate. The challenge in measuring the fair value of these types of intangible assets is that the entity would not have any cash flows if not for the license or permit, yet the entity likely would also have goodwill that is directly responsible for generating the cash flows.

One method that can be utilized to measure this type of intangible asset is the greenfield method. The greenfield method under the income approach assumes that the entity begins operations on the measurement date. Cash flows are forecasted under the assumption that the existing competitive situation continues within each market. The forecasted cash flows assume a start-up of operations. This assumption would then exclude any value of goodwill. Thus, this method isolates the fair value of the licenses or permit to operate directly, separating the value from goodwill.

The greenfield method is illustrated in Section 2.C.3.d.

(2) Market/Income Approach

Some valuation techniques are a combination of more than one approach, such as a combination of the market and income approaches. The market approach β€œuses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business.”12 Reporting entities must adjust quoted prices under the market approach when comparable assets or liabilities transact within active markets or when identical assets or liabilities transact within markets that are not active (as well as in other situations). Adjustments to quoted prices can be based on empirical evidence, such as lack of marketability studies, or on sophisticated formulas, such as those used in valuation multiples and regression (or correlation) analysis. With valuation multiples and regression analysis, the basic idea is to discover a market price of a similar asset or liability and then adjust the price as necessary. A valuation multiple considers one factor at a time while regression analysis typically considers several appropriate factors simultaneously.13

The market approach is easily understood in that it estimates value through transactions of similar assets or business interests in the market. The difficulty in applying the market approach, particularly in estimating the value of intangible assets, is in identifying guideline assets or business interests similar enough to support a valid comparison.15

The relief-from-royalty technique, commonly used when valuing certain types of intangible assets, is a valuation technique that is based on both the income and market approaches.

A. Relief from Royalty    The relief-from-royalty method has characteristics of methods under both market and income approaches. It measures fair value from the perspective that the intangible asset has a value since the entity does not have to pay a third party a royalty to use that intangible asset. The fair value of that right can be measured through an analysis of royalty rates charged by third parties for the use of similar intangible assets. Since the entity already owns the intangible asset, the entity is β€œrelieved from” having to pay a third party a royalty for the use of the intangible asset. The fair value of the intangible asset is the present value of royalty payments that are foregone because the entity owns the intangible asset and does not have to license it from a third party.

The relief-from-royalty method is illustrated in Section 2.C.3.b.

(3) The Cost Approach

The cost approach is based on the amount of cash outlay that would be needed to create an asset of comparable utility. Under the cost approach, an asset is valued based on its current replacement costs, not on its reproduction costs (i.e., the cost to replicate the asset as it is). Replacement costs can be based on the cost to construct an asset with equivalent utility that does not suffer from any imperfections or obsolescence that the asset being valued suffers from.16

The cost approach is often considered, but not often applied, to estimate the fair value of a business enterprise, except for a variation of the approach, which is used in the acquisition method under ASC 805. Rather, the cost approach is often used to estimate the value of specific assets, such as a building or machinery and equipment, or certain intangible assets such as customer relationships.17

A standard definition of the cost approach can be found in the International Glossary of Business Valuation Terms. This resource defines the approach as β€œa general way of determining a value indication of an individual asset by quantifying the amount of money required to replace the future service capability of that asset.”18

A. Reproduction Cost    Reproduction cost is an estimate of all of the costs to reconstruct an intangible asset in current dollars that is an exact replica of the acquired intangible asset. The total costs are then adjusted for any obsolescence of comparing the new asset to the actual asset.

B. Replacement Cost    Replacement cost is an estimate of all the costs to reconstruct an intangible asset, in current dollars, that has the same utility as the acquired intangible asset. The key difference between the reproduction cost and replacement cost is that replacement cost focuses on costs to recreate what the asset does rather than an exact replica.

The replacement cost method is illustrated in Sections 2.C.3.a, 2.C.3.e, and 2.C.3.g of this book.

C. Costs    Both reproduction cost and replacement cost comprise all relevant component costs associated with the acquired intangible asset. Relevant component costs typically consist of such costs as materials, labor, overhead, opportunity costs, and entrepreneurs' profit.

(4) Multiple Valuation Approaches

ASC 820 emphasizes that valuation techniques consistent with the market approach, income approach, and/or cost approach should be used to measure fair value, particularly in a business combination. In some cases a single valuation technique is appropriate. In other situations, multiple valuation techniques will be more appropriate. If multiple valuation techniques are used, the reporting entity should evaluate the results (respective indications of fair value), considering the reasonableness of the range indicated by those results. The fair value measurement is the point within that range that is most representative of fair value in the circumstances.20

C. Applying Valuation Principles to Common Types of Intangible Assets

This section contains a comprehensive example that illustrates commonly accepted valuation principles applied in the measurement of the fair value of specific intangible assets. However, there is variation among valuation specialists as to the application of these methodologies, which is highly dependent on facts and circumstances. The examples are for illustrative purposes only.21

Bestcom Corporation (β€œBestcom”) is an internet-based pharmaceutical company specializing in women's health issues. Bestcom was recently acquired by a private equity firm in a business combination on November 1, 20X1. The private equity firm acquired Bestcom in a cash transaction for approximately $33,000,000. Since the acquisition is considered a business combination for financial reporting, Bestcom must identify the acquired assets, including intangible assets, at their fair values. Management of Bestcom identified the following assets acquired as part of the business combination:

  1. Net working capital
  2. Fixed assets
  3. Customer relationships
  4. Trade name
  5. Proprietary software
  6. Proprietary technology
  7. Government license
  8. Assembled workforce
  9. Non-competition agreement

1. Business Enterprise Value (BEV)

The first step in measuring the fair value of specific identified intangible assets acquired as part of a business combination is to measure the fair value of the entire business enterprise. This measurement is often accomplished through the application of a discounted cash flow analysis. The measurement typically verifies the acquisition price and assists in the verification of the required rate of return of the acquisition and the individual intangible assets. Prospective financial information of debt-free cash flows (PFI) provided by management is discounted to the measurement date at Bestcom's weighted average cost of capital (WACC). The WACC of Bestcom is approximately 17 percent (Table 2.1). The enterprise value (fair value of equity plus assumed debt) of Bestcom is approximately $33,675,000, as shown in Table 2.1.

TABLE 2.1 Discounted Cash Flow Analysis

Bestcom Corporation
As of November 1, 20X1
20X1 20X2 20X3 Terminal Value
Sales $ 32,556,504 100% $ 34,180,001 100% $ 36,572,500 100% $ 37,834,251 100%
Growth 12% 5% 7% 3%
Cost of Sales 19,531,250 60% 21,533,750 63% 23,041,250 63% 23,836,173 63%
Gross Profit 13,025,254 40% 12,646,251 37% 13,531,250 37% 13,998,078 37%
SG&A Expenses 6,884,004 21% 6,493,751 19% 6,948,750 19% 7,188,482 19%
EBITDA 6,141,250 19% 6,152,500 18% 6,582,500 18% 6,809,596 18%
Less: Depreciation 415,000 1% 443,750 1% 475,000 1% 491,388 1%
EBIT 5,726,250 18% 5,708,750 17% 6,107,500 17% 6,318,209 17%
Less: Taxes (2,175,975) βˆ’7% (2,169,325) βˆ’6% (2,320,850) βˆ’6% (2,400,919) βˆ’6%
Debt-Free Net Income 3,550,275 11% 3,539,425 10% 3,786,650 10% 3,917,289 10%
Plus: Depreciation 415,000 1% 443,750 1% 475,000 1% 491,388 1%
Less: Capital Expenditures (415,291) βˆ’1% (436,000) βˆ’1% (475,000) βˆ’1% (491,388) βˆ’1%
Less: Incremental Working Capital (177,825) βˆ’1% (81,175) 0% (119,625) 0% (63,088) 0%
Cash Flows to Invested Capital 3,372,159 10% 3,466,000 10% 3,667,025 10% 3,854,202 10%
Terminal Value 28,444,294
Partial Period 0.16 1.00 1.00 1.00
Period 0.08 0.66 0.66 1.66
Present Value Factor 0.987 0.901 0.770 0.770
Present Value Cash Flows to Invested Capital 547,220 3,122,677 2,823,751 21,903,208
Sum of PV of CF 6,493,648 Assumptions
PV of Terminal Value 21,903,208 Discount Rate (1) 17.0%
Internal Rate of Return (2) 17.5%
Excess Debt-Free Working Capital 350,085 Tax Rate (3) 38.0%
Preliminary Value 28,746,941
Long-term Growth Rate (4) 3.5%
Debt-Free Working Capital % (5) 5.0%
PV of Tax Benefit - Amortization of Intangibles 3,750,363
Enterprise Value, Rounded $ 32,497,000

Notes:

(1) Weighted Average Cost of Capital

(2) Implied Rate, which reconciles the future expected cash flows to the fair value of the acquisition price.

(3) Estimated corporate tax rate.

(4) Based on Management's projections, the growth prospects of the industry and the overall economy.

(5) Based on the industry and company operating working capital requirements excluding debt.

A few items to note in Table 2.1:

  1. The fair value of the BEV is akin to the fair value of the invested capital (equity plus interest bearing debt).
  2. The WACC of Bestcom is estimated to be 17 percent (Table 2.2).

    TABLE 2.2 Weighted Average Cost of Capital (WACC)

    Bestcom Corporation
    As of November 1, 20X1
    Cost of Equity:
    Build-up Method: Ke = Rf + RPm + RPs + RPu 3.45% (1)
    Risk-Free Rate (Rf) 7.10% (2)
    Market Premium (RPm) 5.82% (3)
    Small Company Market Premium (RPs)   2.00% (4)
    Company-Specific Risk Premium (Rpu) Ke = 18.37%
    Capital Asset Pricing Model: Ke = Rf + Ξ²(RPm) + RPs + RPu
    Risk-Free Rate (Rf) 3.45% (1)
    Market Premium B(RPm), where B = 1.143 8.12% (5)
    Small Company Market Premium (RPs) 5.82% (3)
    Company-Specific Risk Premium (Rpu)   2.00% (4)
    Ke = 19.39%
    average Ke = 19.00%
    After Tax Cost of Debt: Kd = Kb(1 βˆ’ t)
    Borrowing Rate (Kb) 5.75% (6)
    Tax Rate (t) 38.00% (7)
    Kd = 3.57%
    Weighted-Average Cost of Capital (WACC) Capital Structure (8) Cost Weighted Cost
    Equity 90.00% 19.00% 17.10%
    Debt 10.00% 3.57%   0.36%  
        WACC = 17.46%
    Rounded = 17.00%

    Notes:

    (1) 20 - Year Treasury Bonds as of November 1, 20X1; Federal Reserve Statistical Release.

    (2) Ibbotson: SBBI: Valuation Edition 20X1 Yearbook: Many valuation specialists add an industry adjustment factor per Ibbotson; however, the adjustment is controversial and there is wide diversity in practice.

    (3) Ibbotson: SBBI: Valuation Edition 20X1 Yearbook: Long-Term Returns in Excess of CAPM Estimations for Decile Portfolios of the NYSE/AMEX/NASDAQ. Typically, from judgment using either the 9th or 10th deciles.

    (4) Based on discussion with management.

    (5) Unlevered Adjusted Beta of 1.07: Ibbotson Cost of Capital 20X1 Yearbook. Relevered using median capital structure of guideline companies and estimated corporate tax rate.

    (6) Moody's Baa rate of November 1, 20X1; Federal Reserve Statistical Release (proxy for marginal borrowing rate).

    (7) Estimated corporate tax rate.

    (8) Based on median level of capital structure for the guideline public companies. Morningstar 20X1 Cost of Capital Yearbook.

  3. The implied internal rate of return of the acquisition is approximately 17.5 percent, which approximates the WACC.
  4. Bestcom had approximately $350,000 in excess working capital as of the date of the acquisition.
  5. The acquired intangible assets and goodwill are assumed to be amortizable for tax reporting purposes. The tax benefit from amortization is included as part of the enterprise value.
  6. Normal levels of working capital are assumed to be 5 percent of revenue.
  7. The blended tax rate is assumed to be 38 percent.

2. Weighted Average Cost of Capital (WACC)

The WACC of Bestcom consists of the required return on an investment in the equity and the after-tax marginal borrowing rate of the company, weighted at the level of debt to equity that market participants would typically finance similar entities. The required return on equity is estimated through both the Capital Asset Pricing Model (CAPM) and an equity build-up method. The marginal cost of debt is assumed to be Moody's Baa corporate rate tax affected at a 38 percent marginal tax rate. The market debt-to-equity level based on similar guideline entities is 90 percent equity and 10 percent debt.

Prior to measuring the fair value of identified intangible assets, the fair values of the acquired net working capital (current assets less current liabilities) and acquired fixed assets are typically measured. Often as a practical expedient the carrying value of net working capital is considered its fair value. Similarly, the carrying value of fixed assets is sometimes considered its fair value under certain circumstances where fixed assets are not a material part of the business combination. Otherwise, fixed asset appraisers, both real estate and personal property, may be retained to provide an opinion of these assets' relative fair values.

After measuring the fair values of the net working capital and fixed assets, the fair values of the specific identified intangible assets are then measured using various valuation techniques as described as follows:

3. Valuation of Specific Intangible Assets

a. Customer Relationships

The fair value of Bestcom's customer relationships is measured using the replacement cost method under the cost approach. Recall that under this method the total cost of obtaining a single new customer is estimated and multiplied by the number of customers that were actually acquired as part of the business transaction. The total cost of obtaining a single new customer is estimated through an analysis of total selling and marketing expenses for the five years prior to the acquisition date and estimating the percentage of these costs that were expended to obtain new customers compared to retaining existing customers. The costs to obtain new customers for this five-year period are summed and divided by the total number of new customers obtained during this period to measure the cost of obtaining an individual customer. The cost to obtain a new customer is then multiplied by the number of customers that existed as of the date of the business combination.

In addition to the actual dollars spent on selling and marketing activities, Bestcom incurred two other types of costs in developing the customer relationships. First, it had to finance the funds expended to develop the relationships. Second, to be consistent with the exit notion of the definition of fair value, if Bestcom were to sell these assets to a market participant, the market participant would require a profit for the use of these resources. The difference between the price to purchase an asset and the cost to create a similar asset can often be attributed to entrepreneurial profit and opportunity cost.

One of the shortcomings of the cost approach to measuring fair value is that traditionally entrepreneurial profit and opportunity costs have not often been included. There are two reasons for this. First, the historical costs on which the cost approach is based often tend not to measure entrepreneurial profit and incentive. This is particularly true for intangible assets because they are typically created or developed internally.

Second, many valuation specialists do not adjust historical costs to include profit and incentive before using historical cost as the basis for the application of the cost approach to the measurement of fair value. A potential solution to this problem is to adjust replacement costs by adding an entrepreneur's profit and opportunity cost. If the entrepreneur's profit and incentive are included in the cost to create an asset, then the fully burdened historical cost would more closely resemble a historical market price and would serve as a better base from which to measure fair value under the cost approach. Thus, under this reasoning, a return on opportunity cost of capital used to develop the relationships and a hypothetical profit could be added to the total actual costs to measure the fair value of the customer relationships.

The fair value of the customer relationships acquired as part of the business combination is approximately $968,000, as shown in Table 2.3.

TABLE 2.3 Valuation of Customer Relationships - Cost Approach

Bestcom Corporation
As of November 1, 20X1
Year Total Selling & Marketing Expense % of Cost from New Customers Selling Costs for New Customers Number of New Customers
20X1 (1) $ 338,042 60.0% $ 202,825 40
20X0 405,101 58.0% 234,959 42
20W9 374,256 65.0% 243,267 38
20W8 413,543 60.0% 248,126 17
20W7 221,415 55.0%      121,779        22
Total  $ 1,050,955       159
 
Total Selling Costs for New Customers 1,050,955
Divided by Total New Customers      159
Cost per New Customer 6,610
Times the Number of Customers as of November 1, 20X1       93
Total Selling & Marketing Cost for Existing Customers 614,709
Opportunity Cost (2.5 year to Recreate) 2.5 (2) 18% (2) 276,619
Entrepreneur's Profit (2.5 Years to Recreate) 2.5 (2) 5% (2)    76,839
Before Tax Replacement Cost of Existing Customers 968,167
Fair Value of Customer Relationships, rounded   968,000

Notes:

(1) 20X1 is projected full year.

(2) Per Management.

b. Trade Name

The fair value of the Bestcom trade name is measured through the relief-from-royalty method. This method measures the fair value through the application of a market royalty to the revenue realized through the use of the trade name. The term relief from royalty acknowledges that since the entity owns the trade name it is β€œrelieved” from paying a royalty to a third party for the use of the name.

The first step in this method is to analyze publicly available information about the licensing of similar names. An analysis of market royalty rates indicates that the market rate for use of trade names similar to the β€œBestcom” name is approximately 2 percent of revenue.

The terms of the publicly available license agreements include:

  1. The royalty rate paid, the economic measure to which the royalty rate is applied
  2. The geographic region
  3. The exclusivity of the agreement
  4. The time period of the agreement

Additionally, the agreements should be compared to the subject entity to consider any additional risks of the subject entity. If there are significant differences, the market royalties can be adjusted to reflect these risks. The industry for these agreements should also be considered because it could provide a framework to determine the appropriate royalty rate the market can support.

The fair value of the Bestcom trade name is the after-tax cash flows from the application of this royalty rate to Bestcom's PFI discounted to the acquisition date at a rate of return commensurate with the risk of the trade name. The fair value of the Bestcom trade name was estimated to be $1,416,000 as shown in Table 2.4.

TABLE 2.4 Valuation of Tradename: Relief-from-Royalty Method

Bestcom Corporation
As of November 1, 20X1
20X1 20X2 20X3 / 20Y1
Revenue $ 32,556,504 100% $ 34,180,001 100% $ 36,572,500 100% $ 50,843,426 100%
Growth 12% 5% 7% / 3.5%
Pre-Tax Royalty Savings 325,565   1% 341,800   1% 365,725   1% / 508,434   1%
Less: Taxes (123,715)   0% (129,884)   0% (138,976)   0% (193,208)   0%
After-Tax Royalty Savings 201,850   1% 211,916   1% 226,750   1% / 315,229   1%
Partial Period 0.16 1.00 1.00 / 0.84
Period 0.08 0.66 1.66 9.66
Present Value Factor 0.986 0.896 0.759 / 0.202
Present Value of After-Tax Royalty Savings 32,733 189,848 172,150 53,203
Sum of PV of Savings 1,224,937 Assumptions
Amortization Benefit Multiplier 1.16 Discount Rate (1) 18.0%
Preliminary Value 1,415,698 Long-term Growth Rate (2) 3.5%
Tax Rate (3) 38.0%
Concluded Value, Rounded    1,416,000 Royalty Rate (4) 1.0%
Remaining Useful Life (5) 10 Years

Notes:

(1) The discount rate is equal to the WACC plus a 1% premium.

(2) Based on discussions with Management, growth prospects for the industry and the overall economy.

(3) Estimated corporate tax rate.

(4) Royalty rate based on industry rates and considering the Company's name is not registered.

(5) Based on discussions with Management and information from guideline public companies.

(6) Represents the present value of the estimated tax benefit derived from the amortization of the intangible asset, over the tax life (15 years) of the asset, based on a 19% required rate of return.

c. Proprietary Technology

The fair value of the asset that is the primary generator of cash flows for the entity is typically measured through the use of the multi-period excess earning method (MPEEM). The MPEEM is a variation of the discounted cash flow (DCF) analysis that isolates cash flows of a specific asset or asset group from the cash flows of the overall entity.

Cash flows attributable to the proprietary technology are isolated from total cash flows of the entire enterprise of Bestcom by subtracting the portion of cash flows attributed to all other assets from total entity cash flows. The cash flows attributable to all other assets except for the proprietary technology are identified through a contributory asset charge (CAC). The CAC is a form of economic charge for the use of these assets in generating total cash flows.

Basis of Contributory Charge22

Asset Basis of Contributory Charge
Debt-free working capital After-tax short-term rates, which would be available to market participants. Examples include bank prime rates, commercial paper rates, and 30- to 90-day U.S. Treasuries. Each should be adjusted for entity-specific risk. Consideration should also be given to the mix of debt and equity financing required to fund working capital.
Fixed assets Rates of β€œreturn on” would include financing rates for similar assets for market participants. Examples include observed vendor financing and bank debt available to fund a specific fixed asset. Consideration should be given to a blended mix of debt and equity financing if market participants typically fund these assets with a mixture of debt and equity.
Workforce, customer lists, trademarks and trade names, intangible assets Weighted average cost of capital for market participants, particularly entities with single-product assets, adjusted for the relevant mix of debt and equity. Most intangible assets are 100 percent funded with equity; therefore, an equity rate of return should be considered for those assets.
Technology-based intangible assets Since most technology-based assets are funded with equity, the cost of equity is considered the base. It is adjusted upward for the increased relative risk of the technology-based asset compared to other company assets.
Other intangibles, including IPR&D assets Rates should be consistent with the relative risk of the subject intangible asset. When market participant inputs are available, that information should be used in calculating a required rate of return. Riskier assets such as IPR&D should require higher rates of return.

The residual cash flows after the subtraction of the contributory asset charge are then discounted back to the measurement date at a rate of return to reflect the risk of the investment in the asset. The fair value of the acquired technology is approximately $3,363,000, as shown in Tables 2.5 and 2.6.

TABLE 2.5 Valuation of Technology - Multi-Period Excess Earnings Model

Bestcom Corporation
As of November 1, 20X1
20X1 20X2 20X3 20X4
Projected Revenue Attributable to Technology $27,673,028 $25,635,001 $21,943,500 $17,025,413
Technology % 85% 75% 60% 45%
EBITDA 5,220,063 4,614,375 3,949,500 3,064,531
EBITDA Margin 19% 18% 18% 18%
Less: Depreciation    (352,750)    (332,813)    (285,000)    (221,124)
EBIT $ 4,867,313 $ 4,281,563 $ 3,664,500 $ 2,843,406
Less: Change for Use of Tradename     276,730     256,350     219,435     170,254
Adjusted EBIT $ 4,590,582 $ 4,025,212 $ 3,445,065 $ 2,673,152
Less: Taxes (1,744,421) (1,529,581) (1,309,125) (1,015,798)
Debt-Free Net Income before Contributory Charge 2,846,161 2,495,632 2,135,940 1,657,354
Less: Contributory Asset Charge   (2,337,091)   (2,069,653)   (1,665,036)   (1,214,575)
Contributory Asset Charge as a % of Revenue (4) 8.4% 8.1% 7.6% 7.1%
Debt-Free Cash Flow Attributable to Technology $   509,070 $   425,979 $   470,904 $   442,780
Partial Period 0.16 1.00 1.00 1.00
Period 0.08 0.66 1.66 2.66
Present Value Factor        0.986        0.891        0.749        0.629
Present Value of Debt-Free Cash Flows $    82,495 $   379,486 $   352,528 $   278,549
Sum of PV of DFCF (20X1 to 20X4) 1,093,057 Assumptions
Sum of PV of DFCF (beyond 20X4 1,816,380 Discount Rate (1) 19.0%
Amortization Benefit Multiplier (5)         1.16 Tax Rate (2) 38.0%
Preliminary Value $3,362,526 Remaining Useful Life (3) 15 Years
Concluded Value Technology $3,363,000

Notes:

(1) The discount rate is equal to the WACC plus a 2% premium.

(2) Estimated corporate tax rate.

(3) Based on remaining life of patent.

(4) Charge for the use of the remaining assets that contribute to the cash flow forecast.

(5) Represents the present value of the estimated tax benefit derived from the amortization of the intangible asset, over the tax life (15 years) of the asset, assuming a 19% required rate of return.

TABLE 2.6 Required Return on Contributory Assets

Bestcom Corporation
As of November 1, 20X1
20X1 20X2 20X3 20X4
Total Revenue $32,556,504 $34,180,001 $36,572,500 $39,132,501
Growth 12% 5% 7% 7%
Multiplied by: DFWC % 18.2% 18.2% 18.2% 18.2%
Required Debt-Free Working Capital 5,925,284 6,220,760 6,656,195 7,122,115
Required Working Capital Return 3.6% (1) 211,236 221,770 237,293 253,903
Capital Expenditures (2) 415,291 436,000 475,000 491,388
Less: Depreciation 415,000 443,750 475,000 491,388
Net Fixed Assets Balance $ 3,833,487 $ 3,833,778 $ 3,826,028 $ 3,826,028 $ 3,826,028
Required Return on Capital Investment 6.7% (1) 255,023 254,507 254,507 254,507
Non-Competition Agreement Beginning Value $ 1,092,000
Non-Competition Agreement Required Return 18.0% (1) $   196,560 $   196,560 $   196,560 $   196,560
Assembled Workforce Beginning Value $ 1,245,000
ASWF Required Return 18.0% (1) $   224,100 $   224,100 $   224,100 $   224,100
Customer Relationships Beginning Value $ 968,000
Customer Relationships Required Return 19.0% (1) $   183,920 $   183,920 $   183,920 $   183,920
Software Beginning Value $ 2,356,000
Software Required Return 18.0% (1) $   424,080 $   424,080 $   424,080 $   424,080
Licensing Beginning Value $ 6,970,000
Licensing Required Return 18.0% (1) $ 1,254,600 $ 1,254,600 $ 1,254,600 $ 1,254,600
Required Return on Contributory Assets (as a % of Revenue) 8.4% 8.1% 7.6% 7.1%

Notes:

(1) Required return based on the relative risk of the contributory asset.

(2) Valuation specialists may make the simplifying assumption that capital expenditures are equal to depreciation expense, otherwise based on Management's forecasted capital expenditures and related depreciation.

d. Governmental License

Since Bestcom sells pharmaceuticals online, it must be licensed to operate. Because without the license Bestcom would not have the ability to operate, the license meets the requirement of an identified intangible asset. The fair value of the license is estimated through the use of the greenfield method.

Under this method, Bestcom is assumed to commence operations on the measurement date. Prospective cash flows are adjusted to reflect this start-up assumption. This start-up assumption effectively separates the fair value of the licenser from the residual value of goodwill.

The fair value of the license to operate is approximately $6,970,000 and is presented in Table 2.7.

TABLE 2.7 Valuation of License - Greenfield Method

Bestcom Corporation
As of November 1, 20X1
20X1 20X2 20X3 Terminal Value
Sales $ 11,972,392 100% $ 23,944,783 100% $ 33,522,697 100% $ 34,679,230 100%
Growth 100% 40% 3%
Cost of Sales 8,141,226 68% 15,564,109 65% 21,119,299 63% 21,847,915 63%
Gross Profit $  3,831,165 32% $  8,380,674 35% $ 12,403,398 37% $ 12,831,315 37%
SG&A Expenses 3,591,718 30% 5,986,196 25% 6,369,312 19% 6,589,054 19%
EBITDA 239,448 2% 2,394,478 10% 6,034,085 18% 6,242,261 18%
Less: Depreciation 152,613 1% 310,869 1% 435,216 1% 450,231 1%
EBIT $     86,835 1% $  2,083,609 9% $  5,598,869 17% $  5,792,030 17%
Less: Taxes (32,997) 0% (791,772) βˆ’3% (2,127,570) βˆ’6% (2,200,971) βˆ’6%
Debt-Free Net Income 53,838 0% 1,291,838 5% 3,471,299 10% 3,591,059 10%
Plus: Depreciation 152,613 1% 310,869 1% 435,216 1% 450,231 1%
Less: Capital Expenditures (152,720) βˆ’1% (305,440) βˆ’1% (200,000) βˆ’1% (450,231) βˆ’1%
Less: Incremental Working Capital (598,620) βˆ’5% (598,620) βˆ’3% (478,896) βˆ’1% (57,827) 0%
Cash Flows to Invested Capital $   (544,889) βˆ’5% $  698,648 3% $  3,227,620 10% $  3,533,232 10%
Terminal Value $  24,283,381
Partial Period 0.16 1.00 1.00 1.00
Period 0.08 0.66 1.66 1.66
Present Value Factor 0.986 0.896 0.759 0.759
Present Value Cash Flows to Invested Capital $    (88,361) $   625,894 $  2,450,435 $  18,436,137
Sum of PV of CF 2,987,968 Assumptions
PV of Terminal Value 18,436,137 Discount Rate (1) 1.0%
Preliminary Value $  21,424,105 Tax Rate (2) 38.0%
Long-term Growth Rate (3) 3.5%
Cash Flows from DCF $  (28,396,857) Debt-Free Working Capital % (4) 5.0%
Preliminary Value 6,972,751
Concluded Value License $  6,970,000

Notes:

(1) The discount rate is equal to the WACC plus a 1% premium.

(2) Estimated corporate tax rate.

(3) Based on Management's projections, the growth prospects of the industry, and the overall economy.

(4) Based on industry and company operating working capital requirements, excluding debt.

e. Assembled Workforce

The accounting standards explicitly exclude assembled workforce as an identifiable intangible asset in a business combination23 because workforces typically do not meet the exit notion under the definition of fair value. However, this does not mean that a workforce does not have value. Clearly an acquirer would pay more for an entity that already has a trained workforce than one that has all the other assets but no workforce. Consequently, the fair value of an assembled workforce is often measured as a contributory asset under other valuation methods even if the fair value is not recognized on the post-acquisition balance sheet.

Bestcom as of the date of the business combination has 43 employees. In addition to general management and administrative employees, several of Bestcom's application designers and programmers are considered to be key in the development of the technology of the entity.

The fair value of the assembled workforce is typically measured through the use of methods under the cost approach. The fair value of the acquired workforce is that the acquirer does not have to incur hiring and training costs since these costs have already been expended to obtain the workforce in place as of the date of the business combination.

Management of Bestcom keeps detailed information as to payroll, direct hiring, and training costs. Bestcom also is able to provide data on inefficiency costs for new employees. Effectiveness percentages by employee category range from 70 percent to 90 percent. Bestcom estimates that it takes approximately three to six months for a new employee to achieve full productivity.

The fair value of the assembled and trained workforce is approximately $1,245,000 and is presented in Table 2.8.

TABLE 2.8 Valuation of Assembled Workforce - Cost Approach

Bestcom Corporation
As of November 1, 20X1
Employee Classification Average Annual Salary (1) Fringe Benefits (2) Average Annual Salary with Benefits Total Hiring Cost per Employee Number of Employees Total Hiring Cost
Executive $141,969  $46,850  $188,818  $37,764   5 $  188,818
Sales 111,489 36,791 148,280 29,656  5    148,280
Technical  82,225 27,134 109,359 21,872 16    349,950
Administrative  28,698  9,470  38,168  7,634  6     45,801
Programmers  57,930 19,117  77,047 15,409 14    215,731
Warehouse  32,591 10,755  43,346  8,669  3     26,008
49    974,588
Employee Classification Average Salary with Benefits Percent Effective (1) Number of Months until Full Productivity (1) Inefficiency Training Costs Direct Training Costs Total Training Costs per Employee Number of Employees Total Training Cost
Executive $188,818  90% 6 $9,441   $4,526  $13,967  5 $   69,836
Sales 148,280 90% 3 3,707  2,124 5,831  5     29,154
Technical 109,359 90% 3 2,734  1,551 4,285 16     68,564
Administrative  38,168 90% 3   954  1,419 2,373  6     14,238
Programmers  77,047 80% 3 3,852  1,650 5,502 14     77,033
Warehouse  43,346 70% 3 3,251    773 4,023  3     12,070
49    270,894
Subtotal   1,245,482
Rounded to $1,245,000

Notes:

(1) Information provided by Management.

(2) Estimated to be 33% of average annual salary and benefits, based on discussions with Management.

(3) Estimated by Human Resources based on recent costs for classes and materials.

f. Non-Compete Agreement

The fair value of non-compete agreements is typically measured using the β€œwith or without” method (sometimes called the scenario method). Incremental cash flows resulting from the use of the asset are estimated over the life of the non-compete agreement and discounted to arrive at a present value. The incremental cash flow can be in the form of additional revenues or can be related to cost saving from the use of the non-compete agreement.

The first scenario incorporates the assumption that the non-compete agreement is in place and was considered in developing the acquisition price for the entity. The second scenario projects cash flows assuming the non-compete agreement is not in place and adjusts cash flows for the possibility of competition in absence of the agreement. The difference in the present value of cash flows from the two scenarios is the fair value of the non-compete agreement.

The fair value of Bestcom, calculated using the total invested capital form of the discounted cash flow analysis from Table 2.1, is used as a basis for illustrating the β€œwith versus without” method of measuring the fair value of a non-compete agreement.

Assume that Bestcom's business enterprise value in Table 2.1 includes the benefits from the previous owner's agreement not to compete. It is the β€œwith” scenario. The new owners of Bestcom believe that without the agreement, they could potentially lose 25 percent of revenues in the remainder of 20X1, declining to a 10 percent revenue loss in 20X5. The new owners assume the probability of competition at 20 percent in all years.

Table 2.9 reflects the adjustments for lost revenue due to competition and shows Bestcom's enterprise value β€œwithout” the non-compete agreement. The difference between the enterprise value β€œwith” and β€œwithout” the non-compete agreement represents the preliminary value of the non-compete agreement.

TABLE 2.9 Analysis of Non-Competition Agreement - Scenario (With/Without) Method

Bestcom Corporation
As of November 1, 20X1
20X1 20X2 20X3 Terminal
Revenue $32,556,504 $34,180,001 $36,572,500 $37,834,251
Growth 12% 5% 7% 3%
Revenue Lost to Competition (1) 16,278,252 50% 17,090,001 50% 18,286,250 β€”
Γ— Probability of Competition (1) 30% 30% 30%
Adjusted Revenue $27,673,028 100% $29,053,001 100% $31,086,625 100% $37,834,251 100%
Cost of Sales 16,601,563 60% 18,303,688 63% 19,585,063 63% 23,836,173 63%
Gross Profit $11,071,466 40% $10,749,314 37% $11,501,563 37% $13,998,078 37%
SG&A Expenses 5,851,403 21% 5,519,689 19% 5,906,438 19% 7,188,482 19%
EBITDA $ 5,220,063 19% $ 5,229,625 18% $ 5,595,125 18% $ 6,809,596 18%
Depreciation 352,750 1% 377,188 1% 403,750 1% 491,388 1%
EBIT $ 4,867,313 18% $ 4,852,438 17% $ 5,191,375 17% $ 6,318,209 17%
Less: Taxes (1,849,579) βˆ’7% (1,843,926) βˆ’6% (1,972,723) βˆ’6% (2,400,919) βˆ’6%
Debt-Free Net Income $ 3,017,734 11% $ 3,008,511 10% $ 3,218,653 10% $ 3,917,289 10%
Plus: Depreciation 352,750 1% 377,188 1% 403,750 1% 491,388 1%
Less: Capital Expenditures (352,997) βˆ’1% (370,600) βˆ’1% (403,750) βˆ’1% (491,388) βˆ’1%
Less: Incremental Working Capital 66,349 0% (68,999) 0% (101,681) 0% (63,088) 0%
Cash Flows to Invested Capital $ 3,083,835 $ 2,946,100 $ 3,116,971 $ 3,854,202
Terminal Value in 20X5 $28,444,294
Partial Period 0.16 1.00 1.00 1.00
Period 0.08 0.66 0.66 1.66
Present Value Factor 0.987 0.901 0.770 0.770
Present Value Cash Flows to Invested Capital $   500,432 $ 2,654,275 $ 2,400,189 $21,903,208
Sum of PV of CF including Terminal Value $27,458,104
Debt-Free Working Capital Deficit 350,085 Assumptions
Fair Value without Non-competition Agreement in Place 27,808,189 Discount Rate (4) 17.0%
Fair Value with Non-competition Agreement in Place (3) 28,746,941 Tax Rate (5) 38.0%
Long-term Growth Rate (6) 3.5%
Preliminary Value of Non-Competition Agreement $   938,752 Term of Non-Compete (7) 3 years
Amortization Benefit Multiplier (2) 1.16
Concluded Value of Non-Competition Agreement $ 1,092,000

Notes:

(1) Based on discussions with Management, direct competition would cause a 30% loss in revenue. Management assumes a 30% probability of competition for all years.

(2) Represents the present value of the estimated tax benefit derived from the amortization of the intangible asset, over the tax life (15 years) of the asset, and a 17% required rate of return.

(3) Business enterprise value excluding the tax benefit from amortization of goodwill and intangibles from the Discounted Cash Flow Analysis.

(4) Weighted average cost of capital.

(5) Estimated corporate tax rate.

(6) Based on Management's projections, the growth prospects of the industry and the overall economy.

(7) Per Non-competition Agreement dated December 8, 20X1.

g. Proprietary Software

The fair value of Bestcom's proprietary software is measured using a replacement method under the cost approach. Under this method, the amount of time that would be incurred to recreate the software is estimated and multiplied by a full-burdened hourly rate to estimate a total reproduction cost. However, since the software that was acquired as part of the business combination was not state-of-the-art, an adjustment is made for functional and technological obsolescence of the existing software. The adjustment is based on the particular facts and circumstances of the software and is estimated through discussions with management. Bestcom's proprietary software is assumed to be 25 percent obsolete; thus the reproduction cost is adjusted by this amount.

The fair value of the proprietary software is approximately $2,356,000 and is presented in Table 2.10.

TABLE 2.10 Valuation of Proprietary Software - Cost Approach

Bestcom Corporation
As of November 1, 20X1
Productivity
Lines of Code Lines Per Hour Estimated Hours to Recreate
Module A 36,000 2 18,000
Module B 35,000 3 11,667
Module C 25,000 3 8,333
Module D  29,800 4      7,450
125,800 45,450
Fully Loaded, Hours Rate (1)      69.12
Reproduction Cost $3,141,381
Less: Obsolescence based on Remaining Useful Life 25%   (785,345)
Replacement Cost $2,356,036
Fair Value of Proprietary Software, Rounded $2,356,000
Note:
(1) The fully loaded, hourly rate includes:
Blended Hourly Salary $40.50
Benefits 33% 13.37
Overhead 15% 5.94
Opportunity Cost of Development 18% 7.29
Entrepreneurial Profit 5%   2.03
$69.12

4. Conclusion of Example

Table 2.11 compares the weighted average return (WARA) on the fair values of the individual assets to the weighted average cost of capital (WACC) as one way to assess the reasonableness of the overall analysis. The returns on the individual assets are developed from guidance in the Appraisal Foundation's β€œBest Practices for Valuations in Financial Reporting: Intangible Asset Working Groupβ€”Contributory Assets” (http://www.appraisalfoundation.org).

TABLE 2.11 Reconciliation of Required Rate of Return to WACC

Bestcom Corporation
As of November 1, 20X1
Assets Acquired: At 11/1/20X1 Estimated Required Return Estimated Required Return ($000s)
Required Debt-Free Working Capital, Normalized (1) $    1,453,415 3.57% $         51,814
Fixed Assets 3,833,487 6.65% 255,004
Technology 3,363,000 19.00% 638,970
Tradename 1,416,000 18.00% 254,880
Non-compete Agreement 1,092,000 18.00% 196,560
Assembled Workforce 1,245,000 18.00% 224,100
Customer Relationships 968,000 19.00% 183,920
Software 2,356,000 18.00% 424,080
License 6,970,000 18.00% 1,254,600
Goodwill    8,296,013 22.00%   1,825,123
Total Operating Assets w/ Required DFWC $30,992,915 $5,309,051
Total Required Rate of Return on Acquired Assets 17.10%
WACC 17.00%
Difference 0.10%
Reconciliation to Fair Value of Acquisition Price
Total Operating Assets w/ Required DFWC $30,992,915
Excess Debt-Free Working Capital (6)       350,085
Fair Value of Acquisition Price $31,343,000

Notes:

(1) Required Debt-Free Working Capital is based on median industry requirements.

(2) Assumes that DFWC would be financed with debt at the Company's after-tax borrowing rate.

(3) Assumes fixed assets would be funded with 20% equity and 80% debt.

(4) According to The Appraisal Foundation's Best Practices for Valuations in Financial Reporting: Intangible Asset Working Group-Contributory Assets, β€œSince intangible assets are not typically financed with debt but with equity, the required rate of return for intangible assets is often highly correlated with the equity rates of return.”

(5) The required rate of return for goodwill is equal to the cost of equity plus a 3% premium.

(6) Reconciling item.

D. Valuing Acquired Goodwill

While goodwill is an intangible asset, the term intangible asset in financial accounting refers to intangible assets other than goodwill. The FASB's Master Glossary defines goodwill as β€œan asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.”24 Therefore, goodwill may include intangible assets internally developed by the target company that cannot otherwise be separately recognized (for example, an acquired assembled workforce).

In a business combination, goodwill is the residual amount after the sum of the fair values of the identified assets acquired and liabilities assumed has been subtracted from the fair value of the acquisition price. The FASB indicated that the fair value of goodwill can be measured only as a residual and cannot be measured directly.

The acquiring company recognizes goodwill as of the acquisition date. Goodwill is measured as the excess of (a) over (b):25

  1. The aggregate of the following:
    1. The consideration transferred, generally measured at acquisition-date fair value
    2. The fair value of any noncontrolling interest in the acquiree
    3. In a business combination achieved in stages, the acquisition-date fair value of the acquirer's previously held equity interest in the acquiree
  2. The net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with this topic

If only equity interests are exchanged, then the acquiree's equity interests may be more reliably measured at fair value than the acquirer's equity interests. If this is the case, then the acquirer determines the amount of goodwill by using the acquisition-date fair value of the acquiree's equity interests instead of the acquisition-date fair value of the equity interests transferred.26

If no consideration is transferred in a business combination, then the acquirer uses the acquisition-date fair value of the acquirer's interest in the acquiree determined using a valuation technique.26

Notes

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