Solutions Manual and Test Bank of Intermediate Accounting Kieso Weygandt Warfield 15th edition
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Chapter 6 Accounting and the Time Value of Money
Chapter 6 Accounting and the Time Value of Money
1. What is the time value of money? Why should accountants have an understanding of compound interest, annuities, and present value concepts?
2. Identify three situations in which accounting measures are based on present values. Do these present value applications involve single sums or annuities, or both single sums and annuities? Explain.
3. What is the nature of interest? Distinguish between “simple interest” and “compound interest.”
4. What are the components of an interest rate? Why is it important for accountants to understand these components?
5. Presented below are a number of values taken from compound interest tables involving the same number of periods and the same rate of interest. Indicate what each of these four values represents. (a) 6.71008. (c) .46319. (b) 2.15892. (d) 14.48656.
6. Jose Oliva is considering two investment options for a $1,500 gift he received for graduation. Both investments have 8% annual interest rates. One offers quarterly compounding; the other compounds on a semiannual basis. Which investment should he choose? Why?
7. Regina Henry deposited $20,000 in a money market certificate that provides interest of 10% compounded quarterly if the amount is maintained for 3 years. How much will Regina Henry have at the end of 3 years?
8. Will Smith will receive $80,000 on December 31, 2017 (5 years from now), from a trust fund established by his father. Assuming the appropriate interest rate for discounting is 12% (compounded semiannually), what is the present value of this amount today?
9. What are the primary characteristics of an annuity? Differentiate between an “ordinary annuity” and an “annuity due.”
10. Kehoe, Inc. owes $40,000 to Ritter Company. How much would Kehoe have to pay each year if the debt is retired through four equal payments (made at the end of the year), given an interest rate on the debt of 12%? (Round to two decimal places.)
11. The Kellys are planning for a retirement home. They estimate they will need $200,000 4 years from now to purchase this home. Assuming an interest rate of 10%, what amount must be deposited at the end of each of the 4 years to fund the home price? (Round to two decimal places.)
12. Assume the same situation as in Question 11, except that the four equal amounts are deposited at the beginning of the period rather than at the end. In this case, what amount must be deposited at the beginning of each period? (Round to two decimals.)
13. Explain how the future value of an ordinary annuity interest table is converted to the future value of an annuity due interest table.
14. Explain how the present value of an ordinary annuity interest table is converted to the present value of an annuity due interest table.
15. In a book named Treasure, the reader has to figure out where a 2.2 pound, 24 kt gold horse has been buried. If the horse is found, a prize of $25,000 a year for 20 years is provided. The actual cost to the publisher to purchase an annuity to pay for the prize is $245,000. What interest rate (to the nearest percent) was used to determine the amount of the annuity? (Assume end-of-year payments.)
16. Alexander Enterprises leases property to Hamilton, Inc. Because Hamilton, Inc. is experiencing financial difficulty, Alexander agrees to receive five rents of $20,000 at the end of each year, with the rents deferred 3 years. What is the present value of the five rents discounted at 12%?
17. Answer the following questions. (a) On May 1, 2012, Goldberg Company sold some machinery to Newlin Company on an installment contract basis. The contract required five equal annual payments, with the first payment due on May 1, 2012. What present value concept is appropriate for this situation? (b) On June 1, 2012, Seymour Inc. purchased a new machine that it does not have to pay for until May 1, 2014. The total payment on May 1, 2014, will include both principal and interest. Assuming interest at a 12% rate, the cost of the machine would be the total payment multiplied by what time value of money concept? (c) Costner Inc. wishes to know how much money it will have available in 5 years if five equal amounts of $35,000 are invested, with the first amount invested immediately. What interest table is appropriate for this situation? (d) Jane Hoffman invests in a “jumbo” $200,000, 3-year certificate of deposit at First Wisconsin Bank. What table would be used to determine the amount accumulated at the end of 3 years?
18. Recently, Glenda Estes was interested in purchasing a Honda Acura. The salesperson indicated that the price of the car was either $27,600 cash or $6,900 at the end of each of 5 years. Compute the effective-interest rate to the nearest percent that Glenda would pay if she chooses to make the five annual payments.
19. Recently, property/casualty insurance companies have been criticized because they reserve for the total loss as much as 5 years before it may happen. The IRS has joined the debate because it says the full reserve is unfair from a taxation viewpoint. What do you believe is the IRS position? BRI E F EXERCI S E S 5
BE6-1 Chris Spear invested $15,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years? To what amount would the investment grow in 3 years if the fund earns 8% annual interest compounded semiannually?
BE6-2 Tony Bautista needs $25,000 in 4 years. What amount must he invest today if his investment earns 12% compounded annually? What amount must he invest if his investment earns 12% annual interest compounded quarterly?
BE6-3 Candice Willis will invest $30,000 today. She needs $150,000 in 21 years. What annual interest rate must she earn?
BE6-4 Bo Newman will invest $10,000 today in a fund that earns 5% annual interest. How many years will it take for the fund to grow to $17,100?
BE6-5 Sally Medavoy will invest $8,000 a year for 20 years in a fund that will earn 12% annual interest. If the first payment into the fund occurs today, what amount will be in the fund in 20 years? If the first payment occurs at year-end, what amount will be in the fund in 20 years?
BE6-6 Steve Madison needs $250,000 in 10 years. How much must he invest at the end of each year, at 11% interest, to meet his needs?
BE6-7 John Fillmore’s lifelong dream is to own his own fishing boat to use in his retirement. John has recently come into an inheritance of $400,000. He estimates that the boat he wants will cost $300,000 when he retires in 5 years. How much of his inheritance must he invest at an annual rate of 12% (compounded annually) to buy the boat at retirement?
BE6-8 Refer to the data in
BE6-7. Assuming quarterly compounding of amounts invested at 12%, how much of John Fillmore’s inheritance must be invested to have enough at retirement to buy the boat?
BE6-9 Morgan Freeman is investing $16,380 at the end of each year in a fund that earns 10% interest. In how many years will the fund be at $100,000?
BE6-10 Henry Quincy wants to withdraw $30,000 each year for 10 years from a fund that earns 8% interest. How much must he invest today if the first withdrawal is at year-end? How much must he invest today if the first withdrawal takes place immediately?
BE6-11 Leon Tyler’s VISA balance is $793.15. He may pay it off in 12 equal end-of-month payments of $75 each. What interest rate is Leon paying?
BE6-12 Maria Alvarez is investing $300,000 in a fund that earns 8% interest compounded annually. What equal amounts can Maria withdraw at the end of each of the next 20 years?
BE6-13 Adams Inc. will deposit $30,000 in a 12% fund at the end of each year for 8 years beginning December 31, 2012. What amount will be in the fund immediately after the last deposit?
BE6-14 Amy Monroe wants to create a fund today that will enable her to withdraw $25,000 per year for 8 years, with the first withdrawal to take place 5 years from today. If the fund earns 8% interest, how much must Amy invest today?
BE6-15 Clancey Inc. issues $2,000,000 of 7% bonds due in 10 years with interest payable at year-end. The current market rate of interest for bonds of similar risk is 8%. What amount will Clancey receive when it issues the bonds? 5 5 5 6 6 5 5 6 7 7 7 6 7 8
BE6-16 Zach Taylor is settling a $20,000 loan due today by making 6 equal annual payments of $4,727.53. Determine the interest rate on this loan, if the payments begin one year after the loan is signed.
BE6-17 Consider the loan in
BE6-16. What payments must Zach Taylor make to settle the loan at the same interest rate but with the 6 payments beginning on the day the loan is signed? 7 7 EXERCI S E S
E6-1 (Using Interest Tables) For each of the following cases, indicate (a) to what rate columns, and (b) to what number of periods you would refer in looking up the interest factor. 1. In a future value of 1 table: Annual Number of Rate Years Invested Compounded a. 9% 9 Annually b. 8% 5 Quarterly c. 10% 15 Semiannually 2. In a present value of an annuity of 1 table: Annual Number of Number of Frequency of Rate Years Involved Rents Involved Rents a. 9% 25 25 Annually b. 8% 15 30 Semiannually c. 12% 7 28 Quarterly
E6-2 (Simple and Compound Interest Computations) Lyle O’Keefe invests $30,000 at 8% annual interest, leaving the money invested without withdrawing any of the interest for 8 years. At the end of the 8 years, Lyle withdrew the accumulated amount of money. Instructions (a) Compute the amount Lyle would withdraw assuming the investment earns simple interest. (b) Compute the amount Lyle would withdraw assuming the investment earns interest compounded annually. (c) Compute the amount Lyle would withdraw assuming the investment earns interest compounded semiannually.
E6-3 (Computation of Future Values and Present Values) Using the appropriate interest table, answer each of the following questions. (Each case is independent of the others.) (a) What is the future value of $9,000 at the end of 5 periods at 8% compounded interest? (b) What is the present value of $9,000 due 8 periods hence, discounted at 11%? (c) What is the future value of 15 periodic payments of $9,000 each made at the end of each period and compounded at 10%? (d) What is the present value of $9,000 to be received at the end of each of 20 periods, discounted at 5% compound interest?
E6-4 (Computation of Future Values and Present Values) Using the appropriate interest table, answer the following questions. (Each case is independent of the others). (a) What is the future value of 20 periodic payments of $5,000 each made at the beginning of each period and compounded at 8%? (b) What is the present value of $2,500 to be received at the beginning of each of 30 periods, discounted at 10% compound interest? (c) What is the future value of 15 deposits of $2,000 each made at the beginning of each period and compounded at 10%? (Future value as of the end of the fifteenth period.) (d) What is the present value of six receipts of $3,000 each received at the beginning of each period, discounted at 9% compounded interest?
E6-5 (Computation of Present Value) Using the appropriate interest table, compute the present values of the periodic amounts, shown on page 344, due at the end of the designated periods.
(a) $50,000 receivable at the end of each period for 8 periods compounded at 12%. (b) $50,000 payments to be made at the end of each period for 16 periods at 9%. (c) $50,000 payable at the end of the seventh, eighth, ninth, and tenth periods at 12%.
E6-6 (Future Value and Present Value Problems) Presented below are three unrelated situations. (a) Ron Stein Company recently signed a lease for a new office building, for a lease period of 10 years. Under the lease agreement, a security deposit of $12,000 is made, with the deposit to be returned at the expiration of the lease, with interest compounded at 10% per year. What amount will the company receive at the time the lease expires? (b) Kate Greenway Corporation, having recently issued a $20 million, 15-year bond issue, is committed to make annual sinking fund deposits of $620,000. The deposits are made on the last day of each year and yield a return of 10%. Will the fund at the end of 15 years be sufficient to retire the bonds? If not, what will the deficiency be? (c) Under the terms of his salary agreement, president Juan Rivera has an option of receiving either an immediate bonus of $40,000, or a deferred bonus of $75,000 payable in 10 years. Ignoring tax considerations, and assuming a relevant interest rate of 8%, which form of settlement should Rivera accept?
E6-7 (Computation of Bond Prices) What would you pay for a $100,000 debenture bond that matures in 15 years and pays $10,000 a year in interest if you wanted to earn a yield of: (a) 8%? (b) 10%? (c) 12%?
E6-8 (Computations for a Retirement Fund) Stephen Bosworth, a super salesman contemplating retirement on his fifty-fifth birthday, decides to create a fund on an 8% basis that will enable him to withdraw $25,000 per year on June 30, beginning in 2016 and continuing through 2019. To develop this fund, Stephen intends to make equal contributions on June 30 of each of the years 2012–2015.
Instructions (a) How much must the balance of the fund equal on June 30, 2015, in order for Stephen Bosworth to satisfy his objective? (b) What are each of Stephen’s contributions to the fund?
E6-9 (Unknown Rate) Kross Company purchased a machine at a price of $100,000 by signing a note payable, which requires a single payment of $118,810 in 2 years. Assuming annual compounding of interest, what rate of interest is being paid on the loan?
E6-10 (Unknown Periods and Unknown Interest Rate) Consider the following independent situations. (a) Mark Yoders wishes to become a millionaire. His money market fund has a balance of $148,644 and has a guaranteed interest rate of 10%. How many years must Mark leave that balance in the fund in order to get his desired $1,000,000? (b) Assume that Elvira Lehman desires to accumulate $1 million in 15 years using her money market fund balance of $239,392. At what interest rate must Elvira’s investment compound annually?
E6-11 (Evaluation of Purchase Options) Amos Excavating Inc. is purchasing a bulldozer. The equipment has a price of $100,000. The manufacturer has offered a payment plan that would allow Amos to make 10 equal annual payments of $15,582, with the first payment due one year after the purchase.
Instructions (a) How much total interest will Amos pay on this payment plan? (b) Amos could borrow $100,000 from its bank to finance the purchase at an annual rate of 8%. Should Amos borrow from the bank or use the manufacturer’s payment plan to pay for the equipment?
E6-12 (Analysis of Alternatives) Brubaker Inc., a manufacturer of high-sugar, low-sodium, lowcholesterol frozen dinners, would like to increase its market share in the Sunbelt. In order to do so, Brubaker has decided to locate a new factory in the Panama City, Florida, area. Brubaker will either buy or lease a site depending upon which is more advantageous. The site location committee has narrowed down the available sites to the following three buildings. Building A: Purchase for a cash price of $610,000, useful life 25 years.
Building B: Lease for 25 years with annual lease payments of $70,000 being made at the beginning of the year.
Building C: Purchase for $650,000 cash. This building is larger than needed; however, the excess space can be sublet for 25 years at a net annual rental of $6,000. Rental payments will be received at the end of each year. Brubaker Inc. has no aversion to being a landlord.
Instructions In which building would you recommend that Brubaker Inc. locate, assuming a 12% cost of funds? 5 6 7 8 8 5 5 7 7
E6-13 (Computation of Bond Liability) Messier Inc. manufactures cycling equipment. Recently, the vice president of operations of the company has requested construction of a new plant to meet the increasing demand for the company’s bikes. After a careful evaluation of the request, the board of directors has decided to raise funds for the new plant by issuing $3,000,000 of 11% term corporate bonds on March 1, 2012, due on March 1, 2027, with interest payable each March 1 and September 1. At the time of issuance, the market interest rate for similar financial instruments is 10%.
Instructions As the controller of the company, determine the selling price of the bonds.
E6-14 (Computation of Pension Liability) Calder, Inc. is a furniture manufacturing company with 50 employees. Recently, after a long negotiation with the local labor union, the company decided to initiate a pension plan as a part of its compensation plan. The plan will start on January 1, 2012. Each employee covered by the plan is entitled to a pension payment each year after retirement. As required by accounting standards, the controller of the company needs to report the pension obligation (liability). On the basis of a discussion with the supervisor of the Personnel Department and an actuary from an insurance company, the controller develops the following information related to the pension plan. Average length of time to retirement 15 years Expected life duration after retirement 10 years Total pension payment expected each year after retirement for all employees. Payment made at the end of the year. $800,000 per year The interest rate to be used is 8%.
Instructions On the basis of the information above, determine the present value of the pension liability.
E6-15 (Investment Decision) Derek Lee just received a signing bonus of $1,000,000. His plan is to invest this payment in a fund that will earn 6%, compounded annually.
Instructions (a) If Lee plans to establish the DL Foundation once the fund grows to $1,898,000, how many years until he can establish the foundation? (b) Instead of investing the entire $1,000,000, Lee invests $300,000 today and plans to make 9 equal annual investments into the fund beginning one year from today. What amount should the payments be if Lee plans to establish the $1,898,000 foundation at the end of 9 years?
E6-16 (Retirement of Debt) Alex Hardaway borrowed $90,000 on March 1, 2010. This amount plus accrued interest at 12% compounded semiannually is to be repaid March 1, 2020. To retire this debt, Alex plans to contribute to a debt retirement fund five equal amounts starting on March 1, 2015, and for the next 4 years. The fund is expected to earn 10% per annum.
Instructions How much must be contributed each year by Alex Hardaway to provide a fund sufficient to retire the debt on March 1, 2020?
E6-17 (Computation of Amount of Rentals) Your client, Wyeth Leasing Company, is preparing a contract to lease a machine to Souvenirs Corporation for a period of 25 years. Wyeth has an investment cost of $421,087 in the machine, which has a useful life of 25 years and no salvage value at the end of that time. Your client is interested in earning an 11% return on its investment and has agreed to accept 25 equal rental payments at the end of each of the next 25 years.
Instructions You are requested to provide Wyeth with the amount of each of the 25 rental payments that will yield an 11% return on investment.
E6-18 (Least Costly Payoff) Assume that Sonic Foundry Corporation has a contractual debt outstanding. Sonic has available two means of settlement: It can either make immediate payment of $3,500,000, or it can make annual payments of $400,000 for 15 years, each payment due on the last day of the year.
Instructions Which method of payment do you recommend, assuming an expected effective-interest rate of 8% during the future period?
E6-19 (Least Costly Payoff) Assuming the same facts as those in
E6-18 except that the payments must begin now and be made on the first day of each of the 15 years, what payment method would you recommend? Exercises 345 8 8 5 6 6 7 7 7 346
E6-20 (Expected Cash Flows) For each of the following, determine the expected cash flows. Cash Flow Probability Estimate Assessment (a) $ 4,800 20% 6,300 50% 7,500 30% (b) $ 5,400 30% 7,200 50% 8,400 20% (c) $(1,000) 10% 3,000 80% 5,000 10%
E6-21 (Expected Cash Flows and Present Value) Keith Bowie is trying to determine the amount to set aside so that he will have enough money on hand in 2 years to overhaul the engine on his vintage used car. While there is some uncertainty about the cost of engine overhauls in 2 years, by conducting some research online, Keith has developed the following estimates. Engine Overhaul Probability Estimated Cash Outfl ow Assessment $200 10% 450 30% 600 50% 750 10%
Instructions How much should Keith Bowie deposit today in an account earning 6%, compounded annually, so that he will have enough money on hand in 2 years to pay for the overhaul?
E6-22 (Fair Value Estimate) Killroy Company owns a trade name that was purchased in an acquisition of McClellan Company. The trade name has a book value of $3,500,000, but according to GAAP, it is assessed for impairment on an annual basis. To perform this impairment test, Killroy must estimate the fair value of the trade name. (You will learn more about intangible asset impairments in Chapter 12.) It has developed the following cash flow estimates related to the trade name based on internal information. Each cash flow estimate reflects Killroy’s estimate of annual cash flows over the next 8 years. The trade name is assumed to have no residual value after the 8 years. (Assume the cash flows occur at the end of each year.) Probability Cash Flow Estimate Assessment $380,000 20% 630,000 50% 750,000 30%
Instructions (a) What is the estimated fair value of the trade name? Killroy determines that the appropriate discount rate for this estimation is 8%. Round calculations to the nearest dollar. (b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.
P6-1 (Various Time Value Situations) Answer each of these unrelated questions. (a) On January 1, 2012, Fishbone Corporation sold a building that cost $250,000 and that had accumulated depreciation of $100,000 on the date of sale. Fishbone received as consideration a $240,000 non-interest-bearing note due on January 1, 2015. There was no established exchange price for the building, and the note had no ready market. The prevailing rate of interest for a note of this type on January 1, 2012, was 9%. At what amount should the gain from the sale of the building be reported? (b) On January 1, 2012, Fishbone Corporation purchased 300 of the $1,000 face value, 9%, 10-year bonds of Walters Inc. The bonds mature on January 1, 2022, and pay interest annually beginning January 1, 2013. Fishbone purchased the bonds to yield 11%. How much did Fishbone pay for the bonds? (c) Fishbone Corporation bought a new machine and agreed to pay for it in equal annual installments of $4,000 at the end of each of the next 10 years. Assuming that a prevailing interest rate of 8% applies to this contract, how much should Fishbone record as the cost of the machine? (d) Fishbone Corporation purchased a special tractor on December 31, 2012. The purchase agreement stipulated that Fishbone should pay $20,000 at the time of purchase and $5,000 at the end of each of the next 8 years. The tractor should be recorded on December 31, 2012, at what amount, assuming an appropriate interest rate of 12%? (e) Fishbone Corporation wants to withdraw $120,000 (including principal) from an investment fund at the end of each year for 9 years. What should be the required initial investment at the beginning of the first year if the fund earns 11%?
P6-2 (Various Time Value Situations) Using the appropriate interest table, provide the solution to each of the following four questions by computing the unknowns. (a) What is the amount of the payments that Ned Winslow must make at the end of each of 8 years to accumulate a fund of $90,000 by the end of the eighth year, if the fund earns 8% interest, compounded annually? (b) Robert Hitchcock is 40 years old today and he wishes to accumulate $500,000 by his sixty-fifth birthday so he can retire to his summer place on Lake Hopatcong. He wishes to accumulate this amount by making equal deposits on his fortieth through his sixty-fourth birthdays. What annual deposit must Robert make if the fund will earn 12% interest compounded annually? (c) Diane Ross has $20,000 to invest today at 9% to pay a debt of $47,347. How many years will it take her to accumulate enough to liquidate the debt? (d) Cindy Houston has a $27,600 debt that she wishes to repay 4 years from today; she has $19,553 that she intends to invest for the 4 years. What rate of interest will she need to earn annually in order to accumulate enough to pay the debt?
P6-3 (Analysis of Alternatives) Assume that Wal-Mart Stores, Inc. has decided to surface and maintain for 10 years a vacant lot next to one of its stores to serve as a parking lot for customers. Management is considering the following bids involving two different qualities of surfacing for a parking area of 12,000 square yards. Bid A: A surface that costs $5.75 per square yard to install. This surface will have to be replaced at the end of 5 years. The annual maintenance cost on this surface is estimated at 25 cents per square yard for each year except the last year of its service. The replacement surface will be similar to the initial surface. Bid B: A surface that costs $10.50 per square yard to install. This surface has a probable useful life of 10 years and will require annual maintenance in each year except the last year, at an estimated cost of 9 cents per square yard.
Instructions Prepare computations showing which bid should be accepted by Wal-Mart. You may assume that the cost of capital is 9%, that the annual maintenance expenditures are incurred at the end of each year, and that prices are not expected to change during the next 10 years.
P6-4 (Evaluating Payment Alternatives) Howie Long has just learned he has won a $500,000 prize in the lottery. The lottery has given him two options for receiving the payments: (1) If Howie takes all the money today, the state and federal governments will deduct taxes at a rate of 46% immediately. (2) Alternatively, the lottery offers Howie a payout of 20 equal payments of $36,000 with the first payment occurring when Howie turns in the winning ticket. Howie will be taxed on each of these payments at a rate of 25%.
Instructions Assuming Howie can earn an 8% rate of return (compounded annually) on any money invested during this period, which pay-out option should he choose?
P6-5 (Analysis of Alternatives) Julia Baker died, leaving to her husband Brent an insurance policy contract that provides that the beneficiary (Brent) can choose any one of the following four options. (a) $55,000 immediate cash. (b) $4,000 every 3 months payable at the end of each quarter for 5 years. (c) $18,000 immediate cash and $1,800 every 3 months for 10 years, payable at the beginning of each 3-month period. (d) $4,000 every 3 months for 3 years and $1,500 each quarter for the following 25 quarters, all payments payable at the end of each quarter. 5 7 7 5 7 7
Instructions If money is worth 2?% per quarter, compounded quarterly, which option would you recommend that Brent exercise?
P6-6 (Purchase Price of a Business) During the past year, Stacy McGill planted a new vineyard on 150 acres of land that she leases for $30,000 a year. She has asked you, as her accountant, to assist her in determining the value of her vineyard operation. The vineyard will bear no grapes for the first 5 years (1–5). In the next 5 years (6–10), Stacy estimates that the vines will bear grapes that can be sold for $60,000 each year. For the next 20 years (11–30), she expects the harvest will provide annual revenues of $110,000. But during the last 10 years (31–40) of the vineyard’s life, she estimates that revenues will decline to $80,000 per year. During the first 5 years, the annual cost of pruning, fertilizing, and caring for the vineyard is estimated at $9,000; during the years of production, 6–40, these costs will rise to $12,000 per year. The relevant market rate of interest for the entire period is 12%. Assume that all receipts and payments are made at the end of each year.
Instructions Dick Button has offered to buy Stacy’s vineyard business by assuming the 40-year lease. On the basis of the current value of the business, what is the minimum price Stacy should accept?
P6-7 (Time Value Concepts Applied to Solve Business Problems) Answer the following questions related to Dubois Inc. (a) Dubois Inc. has $600,000 to invest. The company is trying to decide between two alternative uses of the funds. One alternative provides $80,000 at the end of each year for 12 years, and the other is to receive a single lump-sum payment of $1,900,000 at the end of the 12 years. Which alternative should Dubois select? Assume the interest rate is constant over the entire investment. (b) Dubois Inc. has completed the purchase of new Dell computers. The fair value of the equipment is $824,150. The purchase agreement specifies an immediate down payment of $200,000 and semiannual payments of $76,952 beginning at the end of 6 months for 5 years. What is the interest rate, to the nearest percent, used in discounting this purchase transaction? (c) Dubois Inc. loans money to John Kruk Corporation in the amount of $800,000. Dubois accepts an 8% note due in 7 years with interest payable semiannually. After 2 years (and receipt of interest for 2 years), Dubois needs money and therefore sells the note to Chicago National Bank, which demands interest on the note of 10% compounded semiannually. What is the amount Dubois will receive on the sale of the note? (d) Dubois Inc. wishes to accumulate $1,300,000 by December 31, 2022, to retire bonds outstanding. The company deposits $200,000 on December 31, 2012, which will earn interest at 10% compounded quarterly, to help in the retirement of this debt. In addition, the company wants to know how much should be deposited at the end of each quarter for 10 years to ensure that $1,300,000 is available at the end of 2022. (The quarterly deposits will also earn at a rate of 10%, compounded quarterly.) (Round to even dollars.)
P6-8 (Analysis of Alternatives) Ellison Inc., a manufacturer of steel school lockers, plans to purchase a new punch press for use in its manufacturing process. After contacting the appropriate vendors, the purchasing department received differing terms and options from each vendor. The Engineering Department has determined that each vendor’s punch press is substantially identical and each has a useful life of 20 years. In addition, Engineering has estimated that required year-end maintenance costs will be $1,000 per year for the first 5 years, $2,000 per year for the next 10 years, and $3,000 per year for the last 5 years. Following is each vendor’s sale package. Vendor A: $55,000 cash at time of delivery and 10 year-end payments of $18,000 each. Vendor A offers all its customers the right to purchase at the time of sale a separate 20-year maintenance service contract, under which Vendor A will perform all year-end maintenance at a one-time initial cost of $10,000. Vendor B: Forty semiannual payments of $9,500 each, with the first installment due upon delivery. Vendor B will perform all year-end maintenance for the next 20 years at no extra charge. Vendor C: Full cash price of $150,000 will be due upon delivery.
Instructions Assuming that both Vendors A and B will be able to perform the required year-end maintenance, that Ellison’s cost of funds is 10%, and the machine will be purchased on January 1, from which vendor should the press be purchased?
P6-9 (Analysis of Business Problems) James Kirk is a financial executive with McDowell Enterprises. Although James Kirk has not had any formal training in finance or accounting, he has a “good sense” for 8 5 6 7 7 5 7 numbers and has helped the company grow from a very small company ($500,000 sales) to a large operation ($45 million in sales). With the business growing steadily, however, the company needs to make a number of difficult financial decisions in which James Kirk feels a little “over his head.” He therefore has decided to hire a new employee with “numbers” expertise to help him. As a basis for determining whom to employ, he has decided to ask each prospective employee to prepare answers to questions relating to the following situations he has encountered recently. Here are the questions. (a) In 2011, McDowell Enterprises negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were constructed on land owned by the company. On January 1, 2012, McDowell took possession of the leased property. The 20-year lease is effective for the period January 1, 2012, through December 31, 2031. Advance rental payments of $800,000 are payable to the lessor (owner of facilities) on January 1 of each of the first 10 years of the lease term. Advance payments of $400,000 are due on January 1 for each of the last 10 years of the lease term. McDowell has an option to purchase all the leased facilities for $1 on December 31, 2031. At the time the lease was negotiated, the fair value of the truck terminals and freight storage facilities was approximately $7,200,000. If the company had borrowed the money to purchase the facilities, it would have had to pay 10% interest. Should the company have purchased rather than leased the facilities? (b) Last year the company exchanged a piece of land for a non-interest-bearing note. The note is to be paid at the rate of $15,000 per year for 9 years, beginning one year from the date of disposal of the land. An appropriate rate of interest for the note was 11%. At the time the land was originally purchased, it cost $90,000. What is the fair value of the note? (c) The company has always followed the policy to take any cash discounts on goods purchased. Recently, the company purchased a large amount of raw materials at a price of $800,000 with terms 1/10, n/30 on which it took the discount. McDowell has recently estimated its cost of funds at 10%. Should McDowell continue this policy of always taking the cash discount?
P6-10 (Analysis of Lease vs. Purchase) Dunn Inc. owns and operates a number of hardware stores in the New England region. Recently, the company has decided to locate another store in a rapidly growing area of Maryland. The company is trying to decide whether to purchase or lease the building and related facilities. Purchase: The company can purchase the site, construct the building, and purchase all store fixtures. The cost would be $1,850,000. An immediate down payment of $400,000 is required, and the remaining $1,450,000 would be paid off over 5 years at $350,000 per year (including interest payments made at end of year). The property is expected to have a useful life of 12 years, and then it will be sold for $500,000. As the owner of the property, the company will have the following out-of-pocket expenses each period. Property taxes (to be paid at the end of each year) $40,000 Insurance (to be paid at the beginning of each year) 27,000 Other (primarily maintenance which occurs at the end of each year) 16,000 $83,000 Lease: First National Bank has agreed to purchase the site, construct the building, and install the appropriate fixtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs for the lease would be $270,000. Dunn would have no responsibility related to the facility over the 12 years. The terms of the lease are that Dunn would be required to make 12 annual payments (the first payment to be made at the time the store opens and then each following year). In addition, a deposit of $100,000 is required when the store is opened. This deposit will be returned at the end of the twelfth year, assuming no unusual damage to the building structure or fixtures.
Instructions Which of the two approaches should Dunn Inc. follow? (Currently, the cost of funds for Dunn Inc. is 10%.)
P6-11 (Pension Funding) You have been hired as a benefit consultant by Jean Honore, the owner of Attic Angels. She wants to establish a retirement plan for herself and her three employees. Jean has provided the following information: The retirement plan is to be based upon annual salary for the last year before retirement and is to provide 50% of Jean’s last-year annual salary and 40% of the last-year annual salary for each employee. The plan will make annual payments at the beginning of each year for 20 years from the date of retirement. Jean wishes to fund the plan by making 15 annual deposits beginning January 1, 2012. Invested funds will earn 12% compounded annually. Information about plan participants as of January 1, 2012, is as follows. Jean Honore, owner: Current annual salary of $48,000; estimated retirement date January 1, 2037. Colin Davis, flower arranger: Current annual salary of $36,000; estimated retirement date January 1, 2042. Problems 349 5 7 8 Anita Baker, sales clerk: Current annual salary of $18,000; estimated retirement date January 1, 2032. Gavin Bryars, part-time bookkeeper: Current annual salary of $15,000; estimated retirement date January 1, 2027. In the past, Jean has given herself and each employee a year-end salary increase of 4%. Jean plans to continue this policy in the future.
Instructions (a) Based upon the above information, what will be the annual retirement benefit for each plan participant? (Round to the nearest dollar.) (Hint: Jean will receive raises for 24 years.) (b) What amount must be on deposit at the end of 15 years to ensure that all benefits will be paid? (Round to the nearest dollar.) (c) What is the amount of each annual deposit Jean must make to the retirement plan?
P6-12 (Pension Funding) Craig Brokaw, newly appointed controller of STL, is considering ways to reduce his company’s expenditures on annual pension costs. One way to do this is to switch STL’s pension fund assets from First Security to NET Life. STL is a very well-respected computer manufacturer that recently has experienced a sharp decline in its financial performance for the first time in its 25-year history. Despite financial problems, STL still is committed to providing its employees with good pension and postretirement health benefits. Under its present plan with First Security, STL is obligated to pay $43 million to meet the expected value of future pension benefits that are payable to employees as an annuity upon their retirement from the company. On the other hand, NET Life requires STL to pay only $35 million for identical future pension benefits. First Security is one of the oldest and most reputable insurance companies in North America. NET Life has a much weaker reputation in the insurance industry. In pondering the significant difference in annual pension costs, Brokaw asks himself, “Is this too good to be true?”
Instructions Answer the following questions. (a) Why might NET Life’s pension cost requirement be $8 million less than First Security’s requirement for the same future value? (b) What ethical issues should Craig Brokaw consider before switching STL’s pension fund assets? (c) Who are the stakeholders that could be affected by Brokaw’s decision?
P6-13 (Expected Cash Flows and Present Value) Danny’s Lawn Equipment sells high-quality lawn mowers and offers a 3-year warranty on all new lawn mowers sold. In 2012, Danny sold $300,000 of new specialty mowers for golf greens for which Danny’s service department does not have the equipment to do the service. Danny has entered into an agreement with Mower Mavens to provide all warranty service on the special mowers sold in 2012. Danny wishes to measure the fair value of the agreement to determine the warranty liability for sales made in 2012. The controller for Danny’s Lawn Equipment estimates the following expected warranty cash outflows associated with the mowers sold in 2012. Cash Flow Probability Year Estimate Assessment 2013 $2,500 20% 4,000 60% 5,000 20% 2014 $3,000 30% 5,000 50% 6,000 20% 2015 $4,000 30% 6,000 40% 7,000 30%
Instructions Using expected cash flow and present value techniques, determine the value of the warranty liability for the 2012 sales. Use an annual discount rate of 5%. Assume all cash flows occur at the end of the year.
P6-14 (Expected Cash Flows and Present Value) At the end of 2012, Sawyer Company is conducting an impairment test and needs to develop a fair value estimate for machinery used in its manufacturing operations. Given the nature of Sawyer’s production process, the equipment is for special use. (No secondhand market values are available.) The equipment will be obsolete in 2 years, and Sawyer’s accountants have developed the following cash flow information for the equipment. 350 8 7 9 7 9 Net Cash Flow Probability Year Estimate Assessment 2013 $6,000 40% 9,000 60% 2014 $ (500) 20% 2,000 60% 4,000 20% Scrap value 2014 $ 500 50% 900 50%
Instructions Using expected cash flow and present value techniques, determine the fair value of the machinery at the end of 2012. Use a 6% discount rate. Assume all cash flows occur at the end of the year.
P6-15 (Fair Value Estimate) Murphy Mining Company recently purchased a quartz mine that it intends to work for the next 10 years. According to state environmental laws, Murphy must restore the mine site to its original natural prairie state after it ceases mining operations at the site. To properly account for the mine, Murphy must estimate the fair value of this asset retirement obligation. This amount will be recorded as a liability and added to the value of the mine on Murphy’s books. (You will learn more about these asset retirement obligations in Chapters 10 and 13.) There is no active market for retirement obligations such as these, but Murphy has developed the following cash flow estimates based on its prior experience in mining-site restoration. It will take 3 years to restore the mine site when mining operations cease in 10 years. Each estimated cash outflow reflects an annual payment at the end of each year of the 3-year restoration period. 9 Using Your Judgment 351 Restoration Estimated Probability Cash Outflow Assessment $15,000 10% 22,000 30% 25,000 50% 30,000 10%
Instructions (a) What is the estimated fair value of Murphy’s asset retirement obligation? Murphy determines that the appropriate discount rate for this estimation is 5%. Round calculations to the nearest dollar. (b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain. FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements and accompanying notes of P&G are presented in Appendix 5B or can be accessed at the book’s companion website, www.wiley.com/college/kieso.
Instructions (a) Examining each item in P&G’s balance sheet, identify those items that require present value, discounting, or interest computations in establishing the amount reported. (The accompanying notes are an additional source for this information.) (b) (1) What interest rates are disclosed by P&G as being used to compute interest and present values? (2) Why are there so many different interest rates applied to P&G’s financial statement elements (assets, liabilities, revenues, and expenses)? USING YOUR JUDGMENT
Financial Statement Analysis Case
Consolidated Natural Gas Company Consolidated Natural Gas Company (CNG), with corporate headquarters in Pittsburgh, Pennsylvania, is one of the largest producers, transporters, distributors, and marketers of natural gas in North America. Periodically, the company experiences a decrease in the value of its gas and oil producing properties, and a special charge to income was recorded in order to reduce the carrying value of those assets. Assume the following information: In 2011, CNG estimated the cash inflows from its oil and gas producing properties to be $375,000 per year. During 2012, the write-downs described above caused the estimate to be decreased to $275,000 per year. Production costs (cash outflows) associated with all these properties were estimated to be $125,000 per year in 2011, but this amount was revised to $155,000 per year in 2012.
Instructions (Assume that all cash flows occur at the end of the year.) (a) Calculate the present value of net cash flows for 2011–2013 (three years), using the 2011 estimates and a 10% discount factor. (b) Calculate the present value of net cash flows for 2012–2014 (three years), using the 2012 estimates and a 10% discount factor. (c) Compare the results using the two estimates. Is information on future cash flows from oil and gas producing properties useful, considering that the estimates must be revised each year? Explain.
Accounting, Analysis, and Principles Johnson Co. accepts a note receivable from a customer in exchange for some damaged inventory. The note requires the customer make semiannual installments of $50,000 each for 10 years. The first installment begins six months from the date the customer took delivery of the damaged inventory. Johnson’s management estimates that the fair value of the damaged inventory is $670,591.65.
Accounting (a) What interest rate is Johnson implicitly charging the customer? Express the rate as an annual rate but assume semiannual compounding. (b) At what dollar amount do you think Johnson should record the note receivable on the day the customer takes delivery of the damaged inventory?
Analysis Assume the note receivable for damaged inventory makes up a significant portion of Johnson’s assets. If interest rates increase, what happens to the fair value of the receivable? Briefly explain why.
Principles The Financial Accounting Standards Board recently issued an accounting standard that allows companies to report assets such as notes receivable at fair value. Discuss how fair value versus historical cost potentially involves a trade-off of one desired quality of accounting information against another.
Professional Research At a recent meeting of the accounting staff in your company, the controller raised the issue of using present value techniques to conduct impairment tests for some of the company’s fixed assets. Some of the more senior members of the staff admitted having little knowledge of present value concepts in this context, but they had heard about a FASB Concepts Statement that may be relevant. As the junior staff in the department, you have been asked to conduct some research of the authoritative literature on this topic and report back at the staff meeting next week.
Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and access the FASB Statements of Financial Accounting Concepts. When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.) (a) Identify the recent concept statement that addresses present value measurement in accounting. (b) What are some of the contexts in which present value concepts are applied in accounting measurement? (c) Provide definitions for the following terms: (1) Best estimate. (2) Estimated cash flow (contrasted to expected cash flow). (3) Fresh-start measurement. (4) Interest methods of allocation.
Professional Simulation In this simulation, you are asked to address questions concerning the application of time value of money concepts to accounting problems. Prepare responses to all parts.
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