Question

Murphy Mining Company recently purchased a quartz mine that it intends to work for the next 10 years. According to state environmental laws, Murphy must restore the mine site to its original natural prairie state after it ceases mining operations at the site. To properly account for the mine, Murphy must estimate the fair value of this asset retirement obligation. This amount will be recorded as a liability and added to the value of the mine on Murphy’s books. (You will learn more about these asset retirement obligations in Chapters 10 and 13.) There is no active market for retirement obligations such as these, but Murphy has developed the following cash flow estimates based on its prior experience in mining-site restoration. It will take 3 years to restore the mine site when mining operations cease in 10 years. Each estimated cash outflow reflects an annual payment at the end of each year of the 3-year restoration period.

Restoration Estimated Probability Cash Outflow Assessment $15,000 10% 22,000 30% 25,000 50% 30,000 10%

Instructions (a) What is the estimated fair value of Murphy’s asset retirement obligation? Murphy determines that the appropriate discount rate for this estimation is 5%. Round calculations to the nearest dollar. (b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.

Short answer

The present value is $20,681 and it is a level 3 fair value estimation.

Step-by-step solution

Calculation of present value

Restoration estimated cash outflows	Probability assessment	PV factor	Amount
A	B	C	A*B*C
15,000	10%	0.95238	1,429
22,000	30%	0.90703	5,986
25,000	50%	0.86384	10,798
30,000	10%	0.82270	2,468
		Present value	20,681

Explanation for the level of the fair value of estimation

The estimation developed in part A is the level 3 fair value of estimation. As it is computed by using the complex model of present values.