Question

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.

Short answer

The estimated fair value will be $3,539,930, and it is a level 3 fair value estimate.

Step-by-step solution

Computation of expected cash flow

$$\begin{gathered} \mathbf{Expected}\mathbf{}\mathbf{Annual}\mathbf{}\mathbf{cashflow}\mathbf{=}\mathbf{Cashflow}\mathbf{\times }\mathbf{Probability} \\ \mathbf{=}\mathbf{380}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{20}\mathbf{\%}\mathbf{+}\mathbf{630}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{50}\mathbf{\%}\mathbf{+}\mathbf{750}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{30}\mathbf{\%} \\ \mathbf{=}\mathbf{76}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{315}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{225}\mathbf{,}\mathbf{000} \\ \mathbf{=}\mathbf{\$}\mathbf{616}\mathbf{,}\mathbf{000} \end{gathered}$$

Calculation of estimated fair value

$$\begin{gathered} \mathbf{Estimated}\mathbf{}\mathbf{fair}\mathbf{}\mathbf{value}\mathbf{=}\mathbf{Present}\mathbf{}\mathbf{Value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{expected}\mathbf{}\mathbf{cashflow} \\ \mathbf{=}\mathbf{616}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{5}\mathbf{.}\mathbf{74664} \\ \mathbf{=}\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{539}\mathbf{,}\mathbf{930} \end{gathered}$$

The estimation developed in part a will be considered the level 3 fair value estimate. It is considered as the level 3 fair value estimate because level 3 assets include those financial assets which are most very less liquid, and their fair value is estimated using various mathematical models, concepts, and some assumptions.