Question & Answer

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 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 2013, 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, 2014, McDowell took possession of the leased property. The

20-year lease is effective for the period January 1, 2014, through December 31, 2033. 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, 2033. 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 purchasedrather 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?

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?

Answer the following questions relatedto 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, 2024, to retire bonds outstanding. The company deposits $200,000 on December 31, 2014, 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 2024. (The quarterly deposits will also earn at a rate of 10%, compounded quarterly.) (Round to even dollars.)

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?

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) $18,00  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 paymentspayable at the end of each quarter.

Instructions

If money is worth 2½% per quarter, compounded quarterly, which option would you recommend that Brent exercise?

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?

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.

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?

Answer each of these unrelated questions.

(a) On January 1, 2014, 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, 2017. 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, 2014, was 9%. At what amount should the gain from the sale of the building be reported?

(b) On January 1, 2014, Fishbone Corporation purchased 300 of the $1,000 face value, 9%, 10-year bonds of Walters Inc. The bonds mature on January 1, 2024, and pay interest annually beginning January

1  2015. 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, 2014. 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, 2014, 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%?

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 salvage 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%.

(b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.

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?

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%

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?

Assume that Sonic Foundry Corporation has a contractual debt outstanding.

Sonic has available two means of settlement. It can either make immediate payment of $2,600,000, or it can make annual payments of $300,000 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?

Your client, Keith Moreland Leasing Company, is preparing a contract to lease a machine to Souvenirs Corporation for a period of 25 years. Moreland has an investment cost of $365,755 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 Moreland with the amount of each of the 25 rental payments that will yield an 11% return on investment.

Jesper Parnevik borrowed $70,000 on March 1, 2012. This amount plus accrued interest at 12% compounded semiannually is to be repaid March 1, 2022. To retire this debt, Jesper plans to contribute to a debt retirement fund five equal amounts starting on March 1, 2017, and for the next

4 years. The fund is expected to earn 10% per annum.

Instructions

How much must be contributed each year by Jesper Parnevik to provide a fund sufficient to retire the debt on March 1, 2022?

Andrew Bogut just received a signing bonus of $1,000,000. His plan is to invest this payment in a fund that will earn 8%, compounded annually.

Instructions

(a) If Bogut plans to establish the AB Foundation once the fund grows to $1,999,000, how many years until he can establish the foundation?

(b) Instead of investing the entire $1,000,000, Bogut 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 Bogut plans to establish the $1,999,000 foundation at the end of 9 years?

Nerwin, 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, 2014. Each employee covered by the plan is entitled to a pension payment each year after retirement. As required by accounting

 tandards, 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. $700,000 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 obligation (liability).

George 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’s bikes. After a careful evaluation of the request, the board of directorshas decided to raise funds for the new plant by issuing $2,000,000 of 11% term corporate bonds on March 1, 2014, due on March 1, 2029, 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.

The Black Knights Inc., a manufacturer of low-sugar, low-sodium, low-cholesterol TV dinners, would like to increase its market share in the Sunbelt. In order to do so, Black Knights has decided to locate a new factory in the Panama City area. Black Knights 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 $600,000, useful life 25 years.

Building B: Lease for 25 years with annual lease payments of $69,000 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 $7,000. Rental payments will be received at the end of each year. The Black Knights Inc. has no aversion to being a landlord.

Instructions

In which building would you recommend that The Black Knights Inc. locate, assuming a 12% cost of funds?

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’s payment plan to pay for the equipment?

Consider the following independent situations.

(a) Mike Finley wishes to become a millionaire. His money market fund has a balance of $92,296 and has a guaranteed interest rate of 10%. How many years must Mike leave that balance in the fund in order to get his desired $1,000,000?

(b) Assume that Sally Williams desires to accumulate $1 million in 15 years using her money market fund balance of $182,696. At what interest rate must Sally’s investment compound annually?

LEW Company purchased a machine at a price of $100,000 by signing a note payable, which requires a single payment of $123,210 in 2 years. Assuming annual compounding of interest, what rate of interest is being paid on the loan?

Clarence Weatherspoon, 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 $20,000 per year on June 30, beginning in 2018 and continuing through 2021. To develop this fund, Clarence intends to make equal contributions on June 30 of each of the years 2014–2017.

Instructions

(a) How much must the balance of the fund equal on June 30, 2017, in order for Clarence Weatherspoon to satisfy his objective?

(b) What are each of Clarence’s contributions to the fund?

What would you pay for a $50,000 debenture bond that matures in 15 years and pays $5,000 a year in interest if you wanted to earn a yield of:

(a) 8%? (b) 10%? (c) 12%?