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Chapter 6: Q9Q (page 301)
Question:What are the primary characteristics of an annuity? Differentiate between an “ordinary annuity” and an “annuity due.”
The annuity has periodic payment and rents occur in beginning in annuities due, rents occur at end of the period in an ordinary annuity
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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 6%. 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?
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 Outflow 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?
Johnson Co. accepts a note receivable from a customer in exchange for some damaged inventory. The note requires the customer make semiannual installments of \(50,000 each for 10 years. The first installment begins six months from the date the customer takes delivery of the damaged inventory. Johnson’s management estimates that the fair value of the damaged inventory is \)679,517.
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 has 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.
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: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.
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