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Chapter 6: Q1Q (page 301)
Question: What is the time value of money? Why should accountants have an understanding of compound interest, annuities, and present value concepts?
The time value of money is described as the relation between money and time. The accountants should have knowledge of the mentioned concepts.
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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鈥檚 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.
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鈥檚 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.
Hincapie 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鈥檚 bikes. After a careful evaluation of the request, the board of directors has decided to raise funds for the new plant by issuing $2,000,000 of 11% term corporate bonds on March 1, 2017, due on March 1, 2032, 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
Sosa Excavating Inc. is purchasing a bulldozer. The equipment has a price of \(100,000. The manufacturer has offered a payment plan that would allow Sosa to make 10 equal annual payments of \)16,274.53, with the first payment due one year after the purchase. Instructions (a) How much total interest will Sosa pay on this payment plan? (b) Sosa could borrow $100,000 from its bank to finance the purchase at an annual rate of 9%. Should Sosa borrow from the bank or use the manufacturer鈥檚 payment plan to pay for the equipment?
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.
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 fi xtures. 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 \(500,000. As the owner of the property, the company will have the following outof-pocket expenses each period.
Property taxes (to be paid at the end of each year) \)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
\(83,000
Lease: First National Bank has agreed to purchase the site, construct the building, and install the appropriate fi xtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs for the lease would be \)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 fi rst 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%.)
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