Calculating Equity Investment Purchase Price: A Step-by-Step Guide

Calculating the Purchase Price of an Equity Investment: A Step-by-Step Example

This example demonstrates how to calculate the purchase price of an equity investment using the equity method of accounting.

Scenario: On January 2, 2018, Pharoah Company purchased 25% of the outstanding common stock of Jobs, Inc. and subsequently used the equity method to account for the investment. During 2018, Jobs, Inc. reported net income of $1,180,000 and distributed dividends of $500,000. The ending balance in the Investment in Pharoah Company account at December 31, 2018, was $920,000 after applying the equity method during 2018.

Question: What was the purchase price Pharoah Company paid for its investment in Jobs, Inc?

Solution:

To determine the purchase price, we'll follow these steps:

1. Calculate Total Equity: Since Pharoah Company owns 25% of Jobs, Inc. and their investment is valued at $920,000, we can calculate the total equity of Jobs, Inc.:

   Total Equity of Jobs, Inc. = Ending Balance in Investment / Ownership Percentage Total Equity of Jobs, Inc. = $920,000 / 0.25 = $3,680,000

2. Calculate Retained Earnings: Knowing net income and dividends affect equity, we can calculate Jobs, Inc.'s retained earnings at the end of 2018:

   Retained Earnings of Jobs, Inc. = Total Equity - Net Income + Dividends Retained Earnings of Jobs, Inc. = $3,680,000 - $1,180,000 + $500,000 = $3,000,000

3. Determine Purchase Price: The purchase price equals Pharoah Company's share of Jobs, Inc.'s equity at the time of purchase, which is equivalent to the retained earnings calculated above.

   Purchase Price = Retained Earnings of Jobs, Inc. = $3,000,000

Therefore, the purchase price Pharoah Company paid for its investment in Jobs, Inc. is $3,000,000.