Chapter C11, Problem 1DQ

To determine

Describe the discounted cash flow approach and analyze the underlying assumptions made by the companies while ascertaining the Level 3 fair value estimates using this approach.

Explanation of Solution

Discounted cash flow approach: The discounted cash flow approach compares the initial cash outflow with the present value of the cash inflow.

Level 3 assets: The Level 3 asset refers to the fair-value asset possessing one or more unobservable measures of value.

The evaluation of the value of Level 3 asset:

• To Level 3 assets are generally evaluated through discounted cash flow method.
• The company at times projects the future cash flow as well as their discounted rates, to estimate the value of the assets.

The assumptions underlying this approach are:

• The future cash flow is not known.
• Presence of the risk of default.
• Application of the discount rate is difficult to estimate.
• Prominence of future cash flows and default rate is a significant estimate.
• Difficulty in understanding risk component.