Page 110 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 3: Introduction to Security Analysis

Notes
Example: Assets 20000

Liabilities 5000
Owner’s equity 15000
ABC owns land the historical cost of which is 6000, but currently worth 13000. Market value
of the land is 7000 more than its book value.
PQR ltd. purchases the outstanding stock of ABC for 32000, price based on the market position
and earnings performance of the company over the past few years.
Market value of acquired assets is calculated as follows:
Assets: 20000 + 7000 excess land value = 27000
Market value of acquired liabilities 5000
Market value of net assets 22000

The firm sold all its assets and paid off its liabilities. Purchase price is 32000. Hence, PQR ltd.
will record 10000 as goodwill on the purchase. It must be noted that 7000 from the excess
10000 is attributable to the excess of market value of land over the book value.
Hence 32000 purchase price can be divided into three amounts for accounting purposes:
Acquired company’s owner’s equity 15000
Excess of market value of land 7000

Goodwill 10000
Total purchase price 32000
PQR Ltd. capitalises goodwill and assumes a 10-year period as the economic life of goodwill.
The annual accounting entry for goodwill would be:
Journal entry: Amortisation of goodwill Dr 1000
To goodwill 1000

2. Capitalisation and no amortisation: This method is most beneficial for a company. The
company using this method gets to record the asset in the balance sheet instead of deducting
it from owner’s equity. As there is no amortisation, there is no yearly reduction of net
income. The reason for such a treatment is that goodwill consisting of managerial ability,
reputation and experience generally increases in value over time. This method views
goodwill as an investment and hence it should stay on the balance sheet amortised.
3. Write off method: Under this method, goodwill is immediately written off against the
equity stockholder’s account, generally from retained earnings.

3.10 Summary

Security analysis comprises of an examination and evaluation of the various factors affecting
the value of a security.

Security analysis is about valuing the assets, debt, warrants, and equity of companies from
the perspective of outside investors using publicly available information.
While there is much overlap between the analystical tools used in security analysis and
those used in corporate finance, security analysis tends to take the perspective of potential

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