Is debt paid for during the acquisition in the following example?

Evaluate this example of Goodwill: Company A Buys company B for $100 million in cash. Company B has one asset, which is a factory with a book value of $75 million, debt of $25 million, and equity of $50 million which equals the book value (Assets-Liabilities).


From what I understand, FCI -100 mm, and on the Balance Sheet, Cash -100, PPE +75, and Goodwill +50, so assets = +25, while debt +25, so assets = liabilities


What I don't understand is whether the debt would instead be 0 and the FCI would be -125 as I thought that the debt of the subsidiary was paid during an acquisition, which is why I thought debt was added when calculating the enterprise value of a firm. 


Which of the above is truer in most cases?

 

Based on the most helpful WSO content, when Company A acquires Company B, the treatment of Company B's debt depends on the terms of the acquisition agreement. Typically, in an acquisition:

  1. Debt Assumption: Company A may assume the debt of Company B. This means that Company A takes over the responsibility for the $25 million debt. In this scenario, the debt remains on the balance sheet post-acquisition.

  2. Debt Repayment: Alternatively, Company A could choose to repay Company B's debt as part of the acquisition deal. In this case, Company A would need to provide additional funds to cover the debt, effectively increasing the acquisition cost.

In your example, if Company A does not assume the debt and instead pays it off, the cash consideration effectively becomes $125 million ($100 million purchase price + $25 million to cover the debt). The journal entries would be: - Cash decreases by $125 million. - Property, Plant, and Equipment (PPE) increases by $75 million. - Goodwill is calculated as the purchase price minus the fair value of net assets acquired. If the debt is paid off, the net assets are just the PPE ($75 million), so Goodwill would be $50 million.

Thus, the balance sheet immediately post-acquisition would show: - PPE: $75 million - Goodwill: $50 million - No debt (if it was paid off)

The treatment of debt in the acquisition affects the calculation of Goodwill and the overall financial impact on Company A. It's crucial to know the specific terms of the acquisition agreement to understand how debt is handled.

Sources: POPULAR ACCOUNTING/FINANCE QUESTIONS, How to think about Debt for Acquisitions, Negative Net Debt in an Acquisition, January 2016 Data Update 6: Debt, the double edged sword, Net debt: The definite list

I'm an AI bot trained on the most helpful WSO content across 17+ years.
 

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