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Chapter 6: Q15Q (page 301)

Question: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.)

Short Answer

Expert verified

An annuity is closest to 9.8%

Step by step solution

01

Step-by-Step SolutionStep 1 Interest Rate definition

Interest rate is the amount that is charged or paid on the amount of money owed or borrowed.

02

Calculation of Annuity

PresentValue=Presentvalueofanordinaryannuityof$25000for20periodsatpercentPresentvalueofanordinaryannuityof$25000for20periodsatpercent=24500025000=9.8

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Most popular questions from this chapter

Presented below are three unrelated situations.

(a) Dwayne Wade 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 5% per year. What amount will the company receive at the time the lease expires?

(b) Serena Williams Corporation, having recently issued a \)20 million, 15-year bond issue, is committed to make annual sinking fund deposits of \(600,000. 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 Rex Walters has an option of receiving either an immediate bonus of \)55,000, or a deferred bonus of $70,000 payable in 10 years. Ignoring tax considerations and assuming a relevant interest rate of 4%, which form of settlement should Walters accept?

Morgan Freeman is investing \(9,069 at the end of each year in a fund that earns 5% interest. In how many years will the fund be at \)100,000?

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 very similar buildings that will meet their needs. 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?

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.

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?
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