Accounting and the Time Value of Money

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Tutorial 6

• Accounting and the Time Value of Money

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• E6-4 (Computation of Future Values and Present
  Values) Using the appropriate interest table,
  answer the following questions (each case is
  independent of the others).
• (a) What is the future value of 20 periodic
  payments of 4,000 each made at the beginning of
  each period and compounded at 8?
• Answer

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• (b) What is the present value of 2,500 to be
  received at the beginning of each of 30 periods,
  discounted at 10 compound interest?
• Answer

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• (c) What is the future value of 15 deposits of
  2,000 each made at the beginning of each period
  and compounded at 10? (Future value as of the
  end of the fifteenth period.)
• Answer

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• (d) What is the present value of six receipts of
  1,000 each received at the beginning of each
  period, discounted at 9 compounded interest?
• Answer

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• E6-7 (Computation of Bond Prices) 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?
• Answer

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• (b) 10?
• Answer
• (c) 12?
• Answer

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• E6-12 (Analysis of Alternatives) The Black
  Knights Inc., a manufacturer of high-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?

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• Answer
• Building APV 600,000.
• Building B
• Rent X (PV of annuity due of 25 periods at 12)
  PV
• 69,000 X 8.78432 PV
• 606,118.08 PV
• Building C
• Rent X (PV of ordinary annuity of 25 periods at
  12) PV
• 7,000 X 7.84314 PV
• 54,901.98 PV
• Answer Lease Building C since its present value
  of its net cost is the
• smallest.

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• E6-19 (Computation of Bond Liability) Your
  client, Faith Hill Inc., has acquired Tracy
  Lawrence Manufacturing Company in a business
  combination that is to be accounted for as a
  purchase transaction (at fair market value).
  Along with the assets and business of Tracy
  Lawrence, Faith Hill assumed an outstanding
  debenture bond issue having a principal amount of
  8,000,000 with interest payable semiannually at
  a stated rate of 8. Tracy Lawrence received
  7,300,000 in proceeds from the issuance 5 years
  ago. The bonds are currently 20 years from
  maturity. Equivalent securities command a 12
  rate of interest, interest paid semiannually.
• Instructions
• Your client requests your advice regarding the
  amount to record for the acquired bond issue.

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• Answer

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• E6-24 (Determine Interest Rate) On July 17, 2000,
  Tim McGraw borrowed 42,000 from his grandfather
  to open a clothing store. Starting July 17, 2001,
  Tim has to make ten equal annual payments of
  6,500 each to repay the loan.
• Instructions
• What interest rate is Tim paying?
• Answer

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• P6-1 (Various Time Value Situations) Answer each
  of these unrelated questions.
• (a) On January 1, 2001, Rather Corporation sold a
  building that cost 250,000 and that had
  accumulated depreciation of 100,000 on the date
  of sale. Rather received as consideration a
  275,000 non-interest-bearing note due on January
  1, 2004. 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, 2001, was 9. At
  what amount should the gain from the sale of the
  building be reported?

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• Answer
• (a) Given no established value for the building,
  the fair market value of the note would be
  estimated to value the building.

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• (b) On January 1, 2001, Rather Corporation
  purchased 200 of the 1,000 face value,
  9,10-year bond of Walters Inc. The bonds mature
  on January 1, 2011, and pay interest annually
  beginning January 1, 2002. Rather Corporation
  purchased the bonds to yield 11. How much did
  Rather pay for the bonds?

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• Answer

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• (c) Rather 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
  Rather record as the cost of the machine?
• Answer

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• (d) Rather Corporation purchased a special
  tractor on December 31, 2001. The purchase
  agreement stipulated that Rather 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, 2001, at what
  amount, assuming an appropriate interest rate of
  12?
• Answer

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• (e) Rather Corporation wants to withdraw 100,000
  (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?
• Answer

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• P6-3 (Investment Problem) Mack Aroni, a bank
  robber, is worried about his retirement. He
  decides to start a savings account. Mack deposits
  annually his net share of the "loot," which
  consists of 75,000 per year, for 3 years
  beginning January 1, 2001. Mack is arrested on
  January 4, 2003 (after making the third deposit),
  and spends the rest of 2003 and most of 2004 in
  jail. He escapes in September of 2004. He resumes
  his savings plan with semiannual deposits of
  30,000 each beginning January 1, 2005. Assume
  that the bank's interest rate was 9 compounded
  annually from January 1, 2001, through January 1,
  2004, and 12 annual rate compounded semiannually
  thereafter.
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• (Instructions)
• When Mack retires on January 1, 2008 (6 months
  after his last deposit), what is the balance in
  his savings account?

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• Answer

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• P6-7 (Analysis of Alternatives) Sally Brown died,
  leaving to her husband Linus an insurance policy
  contract that provides that the beneficiary
  (Linus) can choose any one of the following four
  options.
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• (a) 55,000 immediate cash.
• (b) 3,700 every 3 months payable at the end of
  each quarter for 5 years.
• (c) 18,000 immediate cash and 1,600 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 1,200
  each quarter for the following 25 quarters, all
  payments payable at the end of each quarter.
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• Instructions
• If money is worth 2'/z per quarter, compounded
  quarterly, which option would you recommend that
  Linus exercise?

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• Answer

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• P6-9 (Purchase Price of a Business) During the
  past year, Nicole Bobek planted a new vineyard on
  150 acres of land that she leases for 27,000 a
  year. She has asked you as her accountant to
  assist her in determining the value of her
  vineyard operation.
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• The vineyard will bear no grapes for the first 5
  years (1-5). In the next 5 years (6-10), Nicole
  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 100,000. But during
  the last 10 years (31-40) of the vineyard's life
  she estimates that revenues will decline to
  80,000 per year.
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• 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
  10,000 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.
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• Instructions
• Dick Button has offered to buy Nicoles vineyard
  business by assuming the 40-year lease. On the
  basis of the current value of the business what
  is the minimum price Nicole should accept?

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• Answer

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• ETHICS CASE
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• James Qualls, newly appointed controller of KBS,
  is considering ways to reduce his company's
  expenditures on annual pension costs. One way to
  do this is to switch KBS's pension fund assets
  from First Security to NET Life. KBS 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, KBS
  still is committed to providing its employees
  with good pension and postretirement health
  benefits.
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• Under its present plan with First Security, KBS
  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 KBS 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, Qualls asks himself, "Is this too
  good to be true?"
• (c) Who are the stakeholders that could be
  affected by Qualls's decision?

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•  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?
• Answer
• The time value of money would suggest that NET
  Lifes discount rate was substantially lower than
  First Securitys. The actuaries at NET Life are
  making different assumptions about inflation,
  employee turnover, life expectancy of the work
  force, future salary and wage levels, return on
  pension fund assets, etc. NET Life may operate at
  lower gross and net margins and it may provide
  fewer services.  

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• (b) What ethical issues should James Qualls
  consider before switching KBS's pension fund
  assets?
• (B) As the controller of KBS, Qualls assumes a
  fiduciary responsibility to the present and
  future retirees of the corporation. As a result,
  he is responsible for ensuring that the pension
  assets are adequately funded and are adequately
  protected from most controllable risks. At the
  same time, Qualls is responsible for the
  financial condition of KBS. In other words, he is
  obligated to find ethical ways of increasing the
  profits of KBS, even if it means switching
  pension funds to a less costly plan. At times,
  Qualls role to retirees and his role to the
  corporation can be in conflict, especially if
  Qualls is a member of a professional group such
  as CPAs or CMAs.
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• (c) Who are the stakeholders that could be
  affected by Qualls's decision?
• Answer
• (a)             If KBS switched to NET Life
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• The primary beneficiaries of Qualls decision
  would be the corporation and its many
  stockholders by virtue of reducing 8 million
  dollars of annual pension costs.
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• The present and future retirees of KBS may be
  negatively affected by Qualls decision because
  the change of losing a future benefit may be
  increased by virtue of higher risks (as reflected
  in the discount rate and NET Lifes weaker
  reputation).
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• If KBS stayed with First Security
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• In the short run, the primary beneficiaries of
  Qualls decision would be the employees and
  retirees of KBS given the lower risk pension
  asset plan.
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• KBS and its many stakeholders could be negatively
  affected by Qualls decision to stay with First
  Security because of the com-panys inability to
  trim 8 million dollars from its operating
  expenses.