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Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281

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BuyFindarrow_forward

Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281
Textbook Problem
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Present Value Issues Nello Construction Company has just purchased several major pieces of road-building equipment. Because the purchase price is so large, the equipment company is giving Nello an option of choosing one of four different payment plans:

  1. 1. $600,000 immediately in cash.
  2. 2. $200,000 down payment now; $65,000 per year for 12 years, beginning at the end of the current year.

Required:

Nello has asked you to decide which payment plan will provide the smallest present value. The expected effective interest rate during the future periods stated above is 12%.

To determine

Identify the plan which will provide the smallest present value.

Explanation

Present Value: The value of today’s amount expected to be paid or received in the future at a compound interest rate is called as present value.

Identify the plan which will provide the smallest present value.

Plan 1:

Present value of plan 1 is $600,000.

Plan 2:

Present Value: The value of today’s amount expected to be paid or received in the future at a compound interest rate is called as present value.

Determine the present value of $65,000 paid per year for 12 years, using the present value of ordinary annuity formula.

PVO=Cash flow×(pOn,i)=$65,000×(pOn=12,i=12%)=$65,000×6.194374=$402,634.31

Determine the present value of plan 2.

Present value of plan 2 = [Downpayment + Present value of$65,000 paid per year for 12 years]=$200,000+$402,634.31=$602,634.31

Therefore, the present value of plan 2 is $602,634.31.

Plan 3:

Determine the present value of $25,000 paid per year for 3 years, beginning at the end of 5 years, using the present value of ordinary annuity formula.

PVO=Cash flow×(pOn,i)=$25,000×(pOn=3,i=12%)=$25,000×2.401831=$60,045.78

Determine the present value of $75,000 paid per year for 11 years in period 4, beginning at the end of 4th year, using the present value of ordinary annuity formula.

PVO=Cash flow×(pOn,i)=$75,000×(pOn=11,i=12%)=$75,000×5

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