Intermediate Accounting 1
Intermediate Accounting
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Intermediate Accounting 2
E 3.1
Hoda Inc. owns 25% of the common shares ofWillard Corp. The other 75% of the shares are
owned by the Willard family. Hoda acquired the shares eight years ago through a financing
transaction. Each year, Hoda has received a dividend from Willard.Willard has been in business
for 60 years and continues to have strong operations and cash flows. Hoda must determine the
fair value of this investment at its year end. Since there is no market on which theshares are
traded, Hoda must use a discounted cash flow model to determine fair value. Hoda management
intends to hold the shares for five more years, at which time they will sell the sharesto the
Willard family under an existing agreement for $1 million. There is no uncertainty in this
amount.Management expects to receive dividends of $80,000 for each of the five years, although
there is a 20% chance that dividends could be $50,000 each year. The risk-free rate is 4% and the
risk-adjusted rate is 6%.
Q 1) Identify some of the items Hoda will need to consider in determining the fair value of the
investment.
AnsCalculating fair value of an investment involves three basic steps.
Take an estimate of the expected cashflows from the investment you had made.
Select a discounting rate, based on the cost of financing the investment or the
opportunity cost presented by alternative investments.
Then discount the forecasted cashflows back to the present day, using a financial
calculator, a manual calculation or a spreadsheet.
Key Inputs should be
Discount Rate
Cost of Equity, in valuing equity.
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Cost of Capital, in valuing the firm
Cash Flows
Cash Flows to Equity.
Cash Flows to Firm
Growth (to get future cash flows)
Growth in Equity Earnings.
Growth in Firm Earnings (Operating Income)
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Q 2) Calculate the fair value of the investment in Willard using the traditional approach
with factor TablePV.1andPV.2
PV1 Table
Given Rate (Risk
Total Years Pv1 Table value
Number Free)
$1000000 5 4% 4.45182 == 4451820
$80000 5 4% 4.45182 == 4451820
$50000 5 4% 4.45182 == 222591
PV2Table
Given Rate (Risk
Total Years Pv1 Table value
Number Adjusted)
$1000000 5 6% 4.21236 == 4212360
$80000 5 6% 4.21236 == 336988
$50000 5 6% 4.21236 == 210618
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Q 3) Calculate the fair value of the investment using the expected cash flow approach.
Ans.
Given Values are
Fair Value = 10,00,000
No.of years =5
Rate of Interest = 4%
Risk Adjustment Rate = 6%
To Find
Present Value = To Determine
PMT = To Determine
Expected %
Funds Percentage % Value
$50000 20 $10000
$80000 80 $64000
Total 100% $ 74000
Total Div = $74000
Therefore
Fair Value = $1000000
No. of years = 5
I/Y = 4% (0.04)
PMT = $74000
PV = Calculated using financial calculator
Fair value of the investment for the expected cash flow is = $1151361.96
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Q 4) In this case, which discounted cash flow model is the best? Why?
Ans .Discounted cash flow (DCF) method is used to estimate the value of an investment on the
basis of its expected future cash flows. DCF analysis tries to calculate the value of an investment
for today, on the basis of some projections to show how much money it will generate in
the future. This is applicable in the cases where one needs to make changes to their businesses,
such as purchasing new equipment or the expansion of the manufacturing unit.
In this case we can use NPV(Net Present Value) method
NPV is a technique for converting each of these projected annual cash flow amounts into today-
equivalent amounts so that each year’s projected cash flows can be calculated and can be
compared.
In our case we are given very accurate assumptions relating to the profits which the company
will be making in the given set of time frame of 5years.
Intermediate Accounting 7
E 2.11
(a) Discuss the usefulness of a conceptual framework.
Ans. A conceptual framework is an analytical tool. It can be applied in different areas of work
where anbig picture of the scenario is required. The main reason for developing a conceptual
framework are that gives a framework for setting accounting standards, a basis for resolving
accounting disputes and fundamental principles which then do not have to be repeated in
accounting standards. Furthermore, Conceptual Framework can be categorized in terms of the
distinctive function of management accounting within the management process in organizations.
Moreover, the way in which the utility of the outcomes of the management accounting process
can be tested. Conceptual Framework is a criteria which can be used to assess the value of the
processes and work technologies used in management accounting and capabilities necessarily
associated with the effectiveness of the management accounting function overall.
(b) For each of the situations above, list the foundational principle or qualitative
characteristic of financial information that has been violated.
Ans) The list of all the foundational principle for each of the above mentioned case are listed
below
Case 1) The treasurer of Sweet Grapes Corp. would like to prepare financial statements only
during downturns in the company's wine production, which occur periodically when the grape
crop fails. He states that it is at such times that the statements could be most easily prepared. The
company would never allow more than 30 months to pass without statements being prepared.
Observation
Periodicity assumption – Financial Statements must be informed in a timely manner.
Timeliness – User should get information when they needed to make decision.
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Case 2) Tower Manufacturing Ltd. decided to manufacture its own widgets because it would be
cheaper than buying them from an outside supplier. In an attempt to make its statements
comparable with those of its competitors, Tower charged its inventory account for what it felt the
widgets would have cost if they had been purchased from an outside supplier. (Do not use the
revenue recognition principle.)
Observation:-
Historical Cost Principle – Record what you actually paid.
Verifiability – Historical cost is considered as a fact where as others are considered as opinions
Case 3) Cargo Discount Centres buys its merchandise by the truckload and train carload. Cargo
does notinclude any transportation costs in calculating the cost of its ending inventory. Such costs,
althoughthey vary from period to period, are always material in amount.
Observation:-
Historical Cost Principle – Record what you actually paid.
Matching Principle / Comparability – Must match revenues and expenses so that reporting
from different periods are comparable.
Case 4) Quick & Healthy, a fast-food company, sells franchises for $100,000, accepting a $5,000
down paymentand a 25-year note for the remainder. Quick & Healthy promises to assist in site
selection,building, and management training for three years. Quick & Healthy records the full
$100,000 franchisefee as revenue when the contract is signed.
Observation:-
Revenue Recognition & Realization Principle .
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Case 5) Kalil Corp. faces a possible government expropriation (that is, takeover) of its foreign
facilities andpossible losses on amounts that are owed by various customers who are almost
bankrupt. The companypresident has decided that these possibilities should not be noted on the
financial statements because Kalil still hopes that these events will not take place.
Observation:-
Full disclosure
Case 6) Maurice Norris, owner of Rare Bookstore Inc., bought a computer for his own use. He
paid for the computer by writing a cheque on the bookstore chequing account and charged the
Office Equipment
account.
Observation:-
Economic entity and assumptions.
Case 7) Brock Inc. decides that it will be selling its subsidiary, Breck Inc., in a few years. Brock
has excluded Breck's activities from its consolidated financial results.
Observation:-
Economic entity and assumptions.
Case 8) Wilhelm Corporation expensed the purchase of new manufacturing equipment.
Observation:-
Matching Principle.
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Case 9) A large lawsuit has been filed against Mahoney Corp. Mahoney has recorded a loss and
related estimated liability that is equal to the maximum possible amount that it feels it might lose.
Mahoney is confident, however, that either it will win the suit or it will owe a much smaller
amount.
Observation:-
Matching Principle.
P 3.2 M&B Tooling Ltd. is assessing two available options for the purchase of new equipment
with a negotiated cash price of $100,000. The manufacturer is willing to accept a down payment
of 20% of the purchase price and an instalment note for the balance. The note would require
quarterly fixed principal payments (plus interest) starting October 1, 2020,for a period of two
years. M&B has a proposal from its bank for an instalment loan for two years that requires a
fixed blended monthly payment (including both principal and interest) starting August 1, 2020.
The loan would be for 80% of the equipment's purchase price. The current market rate of interest
is 8%. Both contracts have an interest rate of 8%
A) Is there any measurement uncertainty in determining which option is best for
M&B? Which discounted cash flow approach should be used in the comparison of
the two alternatives?
No, there is no measurement uncertainty in determining which option is best for M&B
Tooling Ltd,
The traditional discounted cash flow approach should be used to compare the two
available alternatives.
B) Calculate the amount of the payments required of M&B under each alternative. Use
either a financial calculator or Excel functions
Intermediate Accounting 11
Solution:
Calculation of Total payments and total under both alternatives
Alternative 1st : Qualterly fixed principal and instalments payments
QUARTERLY FIXED PRINCIPAL AND INSTALMENT PAYMENTS
LOAN FIXED BALANCE PAYMEN INTERES
AMOUNT INSTALMENT PAYMENT T T
1 80000 10000 70000 12133.33 2133.33
2 70000 10000 60000 11866.67 1866.67
3 60000 10000 50000 11600.00 1600.00
4 50000 10000 40000 11333.33 1333.33
5 40000 10000 30000 11066.67 1066.67
6 30000 10000 20000 10800.00 800.00
7 20000 10000 10000 10533.33 533.33
8 10000 10000 10266.67 266.67
TOTA
L 89600.00 9600.00
Alternative 2nd: Monthly fixed instalment payments
MONTHLY FIXED INSTALMENT PAYMENTS
FIXED INSTALMENT INTEREST
LOAN AMOUNT PRINCIPAL AMOUNT AMOUNT AMOUNT
1 80000 3084.67 3618 533.33
2 76915.33 3105.23 3618 512.77
3 73810.10 3125.93 3618 492.07
4 70684.17 3146.77 3618 471.23
5 67537.40 3167.75 3618 450.25
6 64369.65 3188.87 3618 429.13
7 61180.78 3210.13 3618 407.87
8 57970.65 3231.53 3618 386.47
9 54739.12 3253.07 3618 364.93
10 51486.05 3274.76 3618 343.24
11 48211.29 3296.59 3618 321.41
12 44914.70 3318.57 3618 299.43
13 41596.13 3340.69 3618 277.31
14 38255.44 3362.96 3618 255.04
15 34892.47 3385.38 3618 232.62
16 31507.09 3407.95 3618 210.05
17 28099.14 3430.67 3618 187.33
18 24668.46 3453.54 3618 164.46
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19 21214.92 3476.57 3618 141.43
20 17738.35 3499.74 3618 118.26
21 14238.61 3523.08 3618 94.92
22 10715.53 3546.56 3618 71.44
23 7168.97 3570.21 3618 47.79
24 3598.76 3594.01 3618 23.99
TOTAL 86832 6836.75
PAYMENT
ALTERNATIVE 1st 89600
ALTERNATIVE 2nd 86832
EXCESS PAYMENTS 2768
So Bank loan should be suggested
C) Besides interest costs, what other considerations should M&B use in making a
choice between the two alternatives?
1) Hidden Cost
2) Present Value factor
3) Processing Cost
4) Prepayment fees
5) Late payment fees
D) What financial ratios could be affected by M&B's choice
1) Debt to Income Ratio
2) Debt Service Coverage Ratio
3) Debt to equity Ratio
4) Return On Capital employed
5) Return on assets
6) Loan to Value Ratio
7) Gearing Ratio
