Clara Holmes, CFA, is attempting to model the importation of an herbal tea into the United States. She gathers 24 years of annual data, which is in millions of inflation-adjusted dollars. The real dollar value of the tea imports has grown steadily from $30 million in the first year of the sample to $54 million in the most recent year.

She computes the following equation:

(Tea Imports)t = 3.8836 + 0.9288 × (Tea Imports)t ? 1 + et

t-statistics (0.9328)(9.0025)

R2 = 0.7942

Adj. R2 = 0.7844

SE = 3.0892

N = 23

Holmes and her colleague, John Briars, CFA, discuss the implication of the model and how they might improve it. Holmes is fairly satisfied with the results because, as she says “the model explains 78.44 percent of the variation in the dependent variable.” Briars says the model actually explains more than that.

Briars asks about the Durbin-Watson statistic. Holmes said that she did not compute it, so Briars reruns the model and computes its value to be 2.1073. Briars says “now we know serial correlation is not a problem.” Holmes counters by saying “rerunning the model and computing the Durbin-Watson statistic was unnecessary because serial correlation is never a problem in this type of time-series model.”

Briars and Holmes decide to ask their company’s statistician about the consequences of serial correlation. Based on what Briars and Holmes tell the statistician, the statistician informs them that serial correlation will only affect the standard errors and the coefficients are still unbiased. The statistician suggests that they employ the Hansen method, which corrects the standard errors for both serial correlation and heteroskedasticity.

Given the information from the statistician, Briars and Holmes decide to use the estimated coefficients to make some inferences. Holmes says the results do not look good for the future of tea imports because the coefficient on (Tea Import)t ? 1 is less than one. This means the process is mean reverting. Using the coefficients in the output, says Holmes, “we know that whenever tea imports are higher than 41.810, the next year they will tend to fall. Whenever the tea imports are less than 41.810, then they will tend to rise in the following year.” Briars agrees with the general assertion that the results suggest that imports will not grow in the long run and tend to revert to a long-run mean, but he says the actual long-run mean is 54.545. Briars then computes the forecast of imports three years into the future.

Part 1)

With respect to the statements made by Holmes and Briars concerning serial correlation and the importance of the Durbin-Watson statistic:

A) Holmes was correct and Briars was incorrect.

B) Briars was correct and Holmes was incorrect.

C) they were both correct.

D) they were both incorrect.

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 6)

Haggerty is using the replacement-chain method, depending only on data from the new factory fact sheet and the cash-flow estimate for the remodeling projects. Which strategy should Haggerty recommend, and what is the difference between that project’s NPV and that of the other project?

Project NPV difference

A) New Factory $1.09 million

B) Remodeling $3.69 million

C) New Factory $1.24 million

D) Remodeling $11.20 million

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 5)

In Year 2 of the new factory project, cash flows will be closest to:

A) $15.61 million.

B) $19.35 million.

C) $23.32 million.

D) $23.11 million.

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 4)

Jenkins advice is correct with respect to:

A) Comments 1 and 2.

B) Comment 4, but incorrect with respect to Comment 1.

C) Comments 3 and 4, but incorrect with respect to Comment 2.

D) Comment 2, but incorrect with respect to Comment 4.

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 3)

Which of the following statements about the effect of inflation on the capital-budgeting process is mostaccurate?

Statement 1: Inflation is reflected in the WACC, but future cash flows should still be adjusted when calculating the NPV.

Statement 2: Inflation will cause the WACC to decrease.

Statement 3: Inflation tends to exert upward pressure on the NPV.

Statement 4: Because the IRR does not depend on the WACC, inflation has no effect on it.

A) Statement 1 only.

B) Statements 2 and 3.

C) Statements 3 and 4.

D) Statements 1 and 2.

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 2)

In the last year of the new factory project, cash flows will be closest to:

A) $95.71 million.

B) $91.74 million.

C) $90.21 million.

D) $88.00 million.

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 1)

If Haggerty decides to properly allocate the maintenance, land-purchase, and equipment-installation expenses Jenkins claimed were connected with the new factory project, which of the followingnumbers on the capital-budgeting model will be least likely to change?

A) The accept/reject recommendation.

B) The initial outlay.

C) Year 4 depreciation.

D) Working capital.

Beta Blocker Systems is a leading drug research and development facility. In the beginning of 2004, it was widely expected to receive approval to market a new beta blocker that it had developed internally. The new drug has significantly fewer side effects than the competing medications currently on the market.

Beta blockers are widely prescribed for a variety of medical conditions, including hypertension, angina, arrhythmias and congestive heart failure. They are also given to heart attack patients to prevent future heart attacks. Because of the widespread use of beta blockers, the market for them is large and their profitability is enormous.

Analysts put the value of the in-process research and development (R&D) for Beta Blocker Systems’ new drug at a whopping $500 million. The expected approval of the drug, and the consequent benefits to any parent companythat might own it, effectively put Beta Blocker Systems into play as an acquisition candidate.

Alphanumeric Research Laboratories, originally founded by Dr. Alka Klimecki, had grown to become a conglomerate with wide-ranging interests in nanotechnology, computer software, biotech, and other industries heavily reliant on research and development. Because of Alphanumeric’s diverse asset base, it was in a position to outbid other firms for Beta Blocker Systems. Alphanumeric Research Labs won the bidding war with an offer of $4.9 billion in Alphanumeric equity to buy out Beta Blocker shareholders. The transaction closed on June 30, 2004. (All balance sheet figures are calculated as of this date.) Alphanumeric recorded the acquisition as a purchase.

The buyout was a windfall for Beta Blocker Systems shareholders. Although the company had very valuable research facilities (shown on its balance sheet at $500 million below its fair market value), it had only $75 million in cash, not enough to fund the necessary development and marketing of the drug on its own without adversely impacting ongoing operations. It had also mismanaged its inventory, allowing much of it to become obsolete and forcing a write-down to its fair market value of $800 million.

The good news on Beta Blocker’s balance sheet was that it had virtually no debt. Owners’ equity stood at $3.335 billion, with the rest of the liabilities side of the balance sheet captured by a small level of current liabilities. However, this lack of debt seriously diluted the return to equity shareholders. Beta Blocker would have earned $40 million in net income in FY2004 (equally distributed throughout the year) if the acquisition had not taken place, providing a paltry return on owners’ equity.

Alphanumeric Research had an even more remarkable lack of leverage. Current liabilities of only $20 million paled in comparison with Alphanumeric’s stunning $4.530 billion in owners’ equity. Alphanumeric also managed its inventory much better than Beta Blocker Systems had. Its balance sheet showed only $500 million in inventory, all of which was current. In fact, Alphanumeric’s inventory had a fair market value 20 percent higher than book value.

Dr. Klimecki was pleased that the acquisition would further reduce Alphanumeric’s already miniscule total liabilities/owners’ equity ratio because of the additional equity issued to fund the purchase. The auditor, Nancy Alsen, added that the current assets/current liabilities ratio would also improve due to the write-up of inventory to fair market value.

Alphanumeric also had $50 million in cash. The remainder of Alphanumeric Systems’ assets were its research facilities, which had a fair market value of $4.2 billion, much larger than the $3 billion fair market value of Beta Blocker’s facilities.

Both Alphanumeric Research Laboratories and Beta Blocker Systems use fiscal years that match the calendar year and report in accordance with IAS standards. They amortize tangible assets over 20 years, and use the straight-line method for depreciation and amortization of both tangible and intangible assets.

Part 6)

Regarding Klimecki’s and Alsen’s statements about the impact of the Beta Systems acquisition on Alphanumeric’s consolidated balance sheet:

A)Klimecki’s statement is correct and Alsen’s statement is incorrect.

B)Klimecki’s statement is correct and Alsen’s statement is correct.

C)Klimecki’s statement is incorrect and Alsen’s statement is incorrect.

D)Klimecki’s statement is incorrect and Alsen’s statement is correct.

Beta Blocker Systems is a leading drug research and development facility. In the beginning of 2004, it was widely expected to receive approval to market a new beta blocker that it had developed internally. The new drug has significantly fewer side effects than the competing medications currently on the market.

Beta blockers are widely prescribed for a variety of medical conditions, including hypertension, angina, arrhythmias and congestive heart failure. They are also given to heart attack patients to prevent future heart attacks. Because of the widespread use of beta blockers, the market for them is large and their profitability is enormous.

Analysts put the value of the in-process research and development (R&D) for Beta Blocker Systems’ new drug at a whopping $500 million. The expected approval of the drug, and the consequent benefits to any parent companythat might own it, effectively put Beta Blocker Systems into play as an acquisition candidate.

Alphanumeric Research Laboratories, originally founded by Dr. Alka Klimecki, had grown to become a conglomerate with wide-ranging interests in nanotechnology, computer software, biotech, and other industries heavily reliant on research and development. Because of Alphanumeric’s diverse asset base, it was in a position to outbid other firms for Beta Blocker Systems. Alphanumeric Research Labs won the bidding war with an offer of $4.9 billion in Alphanumeric equity to buy out Beta Blocker shareholders. The transaction closed on June 30, 2004. (All balance sheet figures are calculated as of this date.) Alphanumeric recorded the acquisition as a purchase.

The buyout was a windfall for Beta Blocker Systems shareholders. Although the company had very valuable research facilities (shown on its balance sheet at $500 million below its fair market value), it had only $75 million in cash, not enough to fund the necessary development and marketing of the drug on its own without adversely impacting ongoing operations. It had also mismanaged its inventory, allowing much of it to become obsolete and forcing a write-down to its fair market value of $800 million.

The good news on Beta Blocker’s balance sheet was that it had virtually no debt. Owners’ equity stood at $3.335 billion, with the rest of the liabilities side of the balance sheet captured by a small level of current liabilities. However, this lack of debt seriously diluted the return to equity shareholders. Beta Blocker would have earned $40 million in net income in FY2004 (equally distributed throughout the year) if the acquisition had not taken place, providing a paltry return on owners’ equity.

Alphanumeric Research had an even more remarkable lack of leverage. Current liabilities of only $20 million paled in comparison with Alphanumeric’s stunning $4.530 billion in owners’ equity. Alphanumeric also managed its inventory much better than Beta Blocker Systems had. Its balance sheet showed only $500 million in inventory, all of which was current. In fact, Alphanumeric’s inventory had a fair market value 20 percent higher than book value.

Dr. Klimecki was pleased that the acquisition would further reduce Alphanumeric’s already miniscule total liabilities/owners’ equity ratio because of the additional equity issued to fund the purchase. The auditor, Nancy Alsen, added that the current assets/current liabilities ratio would also improve due to the write-up of inventory to fair market value.

Alphanumeric also had $50 million in cash. The remainder of Alphanumeric Systems’ assets were its research facilities, which had a fair market value of $4.2 billion, much larger than the $3 billion fair market value of Beta Blocker’s facilities.

Both Alphanumeric Research Laboratories and Beta Blocker Systems use fiscal years that match the calendar year and report in accordance with IAS standards. They amortize tangible assets over 20 years, and use the straight-line method for depreciation and amortization of both tangible and intangible assets.

Part 1)

What is the amount of goodwill (in millions) that Alphanumeric will record on its June 30, 2004 balance sheet to reflect the acquisition of Beta Blocker Systems?

A)$25.

B)$40.

C)$125.

D)$565.

Beta Blocker Systems is a leading drug research and development facility. In the beginning of 2004, it was widely expected to receive approval to market a new beta blocker that it had developed internally. The new drug has significantly fewer side effects than the competing medications currently on the market.

Beta blockers are widely prescribed for a variety of medical conditions, including hypertension, angina, arrhythmias and congestive heart failure. They are also given to heart attack patients to prevent future heart attacks. Because of the widespread use of beta blockers, the market for them is large and their profitability is enormous.

Analysts put the value of the in-process research and development (R&D) for Beta Blocker Systems’ new drug at a whopping $500 million. The expected approval of the drug, and the consequent benefits to any parent companythat might own it, effectively put Beta Blocker Systems into play as an acquisition candidate.

Alphanumeric Research Laboratories, originally founded by Dr. Alka Klimecki, had grown to become a conglomerate with wide-ranging interests in nanotechnology, computer software, biotech, and other industries heavily reliant on research and development. Because of Alphanumeric’s diverse asset base, it was in a position to outbid other firms for Beta Blocker Systems. Alphanumeric Research Labs won the bidding war with an offer of $4.9 billion in Alphanumeric equity to buy out Beta Blocker shareholders. The transaction closed on June 30, 2004. (All balance sheet figures are calculated as of this date.) Alphanumeric recorded the acquisition as a purchase.

The buyout was a windfall for Beta Blocker Systems shareholders. Although the company had very valuable research facilities (shown on its balance sheet at $500 million below its fair market value), it had only $75 million in cash, not enough to fund the necessary development and marketing of the drug on its own without adversely impacting ongoing operations. It had also mismanaged its inventory, allowing much of it to become obsolete and forcing a write-down to its fair market value of $800 million.

The good news on Beta Blocker’s balance sheet was that it had virtually no debt. Owners’ equity stood at $3.335 billion, with the rest of the liabilities side of the balance sheet captured by a small level of current liabilities. However, this lack of debt seriously diluted the return to equity shareholders. Beta Blocker would have earned $40 million in net income in FY2004 (equally distributed throughout the year) if the acquisition had not taken place, providing a paltry return on owners’ equity.

Alphanumeric Research had an even more remarkable lack of leverage. Current liabilities of only $20 million paled in comparison with Alphanumeric’s stunning $4.530 billion in owners’ equity. Alphanumeric also managed its inventory much better than Beta Blocker Systems had. Its balance sheet showed only $500 million in inventory, all of which was current. In fact, Alphanumeric’s inventory had a fair market value 20 percent higher than book value.

Dr. Klimecki was pleased that the acquisition would further reduce Alphanumeric’s already miniscule total liabilities/owners’ equity ratio because of the additional equity issued to fund the purchase. The auditor, Nancy Alsen, added that the current assets/current liabilities ratio would also improve due to the write-up of inventory to fair market value.

Alphanumeric also had $50 million in cash. The remainder of Alphanumeric Systems’ assets were its research facilities, which had a fair market value of $4.2 billion, much larger than the $3 billion fair market value of Beta Blocker’s facilities.

Both Alphanumeric Research Laboratories and Beta Blocker Systems use fiscal years that match the calendar year and report in accordance with IAS standards. They amortize tangible assets over 20 years, and use the straight-line method for depreciation and amortization of both tangible and intangible assets.

Part 5)

Which statement about U.S. GAAP and IAS GAAP is FALSE?

A)The current ratio of the consolidated firm under both accounting standards is typically higher than the pre-acquisition current ratio of either individual firm.

B)Both require capitalization of in-process R&D.

C)Both require write-up of assets to their fair market value.

D)Goodwill is tested annually for impairment under both methods.