Morris Mining Corp Research Paper
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MORRIS MINING CORP
Case 9.5
Morris Mining Corp. (Case 9.5)
Morris Mining Corp. acquired King Co. in January 2015. It is expected that the purchase price will exceed the value of identifiable net assets. The difference in the purchase price and the identifiable net assets will be recorded as goodwill. In order to arrive at the identifiable new assets total, Morris Mining must determine the fair value measurement for a utility patent acquired in the acquisition. The patent is for a new mining machine called the “Extract-o-Matic 1000”. King entered into an agreement with Build-IT, which gives Build-IT exclusive rights (license) to manufacture and sell the Extract-o-Matic 1000 for a period of 12 years. In exchange, King receives yearly royalty payments in the amount of 10 percent of the revenue from the sales of the Extract-o-Matic 1000. Since the acquisition of King, Morris Mining is now entitled to the royalty payments. To determine the fair value of the patent, Chris Carter, CFO of Morris Mining, used the discounted cash flows method to calculate the present value of the cash flows from the expected royalty payments, which is currently in review by external audit. The purpose of this memo is to express the importance of proper valuation and assess the risk that the external auditors will require Morris Mining to write down the patent or get third party appraisals.
According to ASC 350-30-25, goodwill can only be recognized if a whole business is purchased and the purchase price is greater than the market value of the net assets. In addition, unlike other intangible assets, ASC 350-20-35 states that goodwill shall not be amortized, but rather tested for impairment. Therefore, if Morris Mining undervalues their patent, goodwill will be overstated and less amortization expense will be recognized, by which increasing Morris Mining’s taxable base. Lastly, if the royalty payments are more or less than anticipated, it could yield a significant loss or gain. According to ASC 360-10-35-17, an impairment loss on the patent shall be recognized if the carrying amount of a patent is not recoverable and exceeds its fair value. These factors could have a significant impact on tax planning and cash flow, therefore, proper valuation is crucial.
ASC 820-10-55 discusses the fair value valuation approaches: market approach, cost approach, and income approach. The market approach (ASC 820-10-55-3A) uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities, or a group of assets and liabilities, such as a business. The cost approach (ASC 820-10-55-3D) reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost). The income approach (ASC 820-10-55-3F) converts future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. When the income approach is used, the fair market value measurement reflects current market expectations about those future amounts.
Chris Carter’s valuation of the patent uses the income approach (discounted cash flows) and assumes a 10 year useful file, 10 percent discount rate, and a growth rate of 15 percent for years 1 through 4, -5 percent for years 5 through 7, and -15 percent for years 8 through 10. Based on the uniqueness of the machine patent, the asset impairment procedures, and Build-IT’s required license valuation methods for the patent, I feel that the income approach is the most appropriate method of valuation. In addition, after conducting further research, the useful life seem reasonable and common. However, the interest rate appears to be somewhere between 8 to 11 percent, with the lower range being more likely and probably more supportable. In addition, the growth rate may be too conservative, as comparatives have averaged a 22 percent growth rate in earlier years and have seen more than a 15 percent drop in the later years. After plugging these factors into Chris Carter’s valuation, I found that the total present value of cash flows from royalty is extremely sensitive to a change in the discount rate and growth rates, see Sensitivity Testing 1 through 3.
Sensitivity Testing 1 captures a decline in discount rate from 10 percent to 9 percent, yielding an increase in the present value of cash flow from royalty of $1,120,470 and a decrease in the net royalty income of $1,120,470. Assuming that Chris Carter’s growth rates are accurate, this scenario would increase amortization, by which reducing the tax expense for Morris Mining. The reduced tax expense saves Morris Mining cash!
Sensitivity Testing 2 assumes that the discount rate from Chris Carter’s model is unchanged,