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Chapter 6: Q4Q (page 301)

Question:What are the components of an interest rate? Why is it important for accountants to understand these components?

Short Answer

Expert verified

The components of interest rate are pure rate on interest, the expected inflation rate of interest, and credit risk rate of interest. Accountants should have knowledge of these because it will help in choosing the best interest rate for a company.

Step by step solution

01

Step-by-Step solutionStep 1 Components of interest rate

The three components of interest rate are as follows:

Pure rate of interest: It is the amount charged by the lender in the case when there are no possibilities of default and expectation of inflation.

The expected inflation rate of interest: In the inflationary period lenders recognize that they are paid less in form of interest. So, to cover the loss they charge higher interest in a high inflation period.

Credit risk rate of interest: The business organizations can have low or a high credit risk depending upon their financial ability and profitability.

02

Importance to understand the components by the accountants

To identify the best appropriate interest rate for a given company, accountants of the company must have knowledge about the abovementioned components of the interest rate

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Most popular questions from this chapter

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, 2017. 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. $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).

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 2016, 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, 2017, McDowell took possession of the leased property. The 20-year lease is effective for the period January 1, 2017, through December 31, 2036. 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 \(1 on December 31, 2036. At the time the lease was negotiated, the fair value of the truck terminals and freight storage facilities was approximately \)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?

Question:What are the primary characteristics of an annuity? Differentiate between an “ordinary annuity” and an “annuity due.”

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?

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, 2017. Invested funds will earn 12% compounded annually. Information about plan participants as of January 1, 2017, is as follows.

Jean Honore, owner: Current annual salary of \(48,000; estimated retirement date January 1, 2042.

Colin Davis, flower arranger: Current annual salary of \)36,000; estimated retirement date January 1, 2047.

Anita Baker, sales clerk: Current annual salary of \(18,000; estimated retirement date January 1, 2037.

Gavin Bryars, part-time bookkeeper: Current annual salary of \)15,000; estimated retirement date January 1, 2032.

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?
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