Chapter 6: Question 3BE (page 302)
Candice Willis will invest \(30,000 today. She needs \)150,000 in 21 years. What annual interest rate must she earn?
The annual interest rate that she must earn is 5%.
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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.
Dunn Inc. owns and operates a number of hardware stores in the New England region. Recently, the company has decided to locate another store in a rapidly growing area of Maryland. The company is trying to decide whether to purchase or lease the building and related facilities.
Purchase: The company can purchase the site, construct the building, and purchase all store fi xtures. The cost would be \(1,850,000. An immediate down payment of \)400,000 is required, and the remaining \(1,450,000 would be paid off over 5 years at \)350,000 per year (including interest payments made at end of year). The property is expected to have a useful life of 12 years, and then it will be sold for \(500,000. As the owner of the property, the company will have the following outof-pocket expenses each period.
Property taxes (to be paid at the end of each year) \)40,000
Insurance (to be paid at the beginning of each year) 27,000
Other (primarily maintenance which occurs at the end of each year) 16,000
\(83,000
Lease: First National Bank has agreed to purchase the site, construct the building, and install the appropriate fi xtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs for the lease would be \)270,000. Dunn would have no responsibility related to the facility over the 12 years. The terms of the lease are that Dunn would be required to make 12 annual payments (the fi rst payment to be made at the time the store opens and then each following year). In addition, a deposit of $100,000 is required when the store is opened. This deposit will be returned at the end of the twelfth year, assuming no unusual damage to the building structure or fixtures.
Instructions Which of the two approaches should Dunn Inc. follow? (Currently, the cost of funds for Dunn Inc. is 10%.)
What would you pay for a \(100,000 debenture bond that matures in 15 years and pays \)5,000 a year in interest if you wanted to earn a yield of: (a) 4%? (b) 5%? (c) 6%?
Morgan Freeman is investing \(9,069 at the end of each year in a fund that earns 5% interest. In how many years will the fund be at \)100,000?
Consolidated Natural Gas Company (CNG), with corporate headquarters in Pittsburgh, Pennsylvania, is one of the largest producers, transporters, distributors, and marketers of natural gas in North America.
Periodically, the company experiences a decrease in the value of its gas- and oil-producing properties, and a special charge to income was recorded in order to reduce the carrying value of those assets.
Assume the following information. In 2016, CNG estimated the cash inflows from its oil- and gas-producing properties to be \(375,000 per year. During 2017, the write-downs described above caused the estimate to be decreased to \)275,000 per year. Production costs (cash outflows) associated with all these properties were estimated to be \(125,000 per year in 2016, but this amount was revised to \)155,000 per year in 2017.
Instructions (Assume that all cash flows occur at the end of the year.)
(a) Calculate the present value of net cash flows for 2016–2018 (three years), using the 2016 estimates and a 10% discount factor.
(b) Calculate the present value of net cash flows for 2017–2019 (three years), using the 2017 estimates and a 10% discount factor.
(c) Compare the results using the two estimates. Is information on future cash flows from oil- and gas-producing properties useful, considering that the estimates must be revised each year? Explain.
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