Part 1. Tucker Company has an asset in the form of a cash flow that it expects to collect in three years. However, the amount of the cash flow is not certain. These are the probabilities underlying the cash flow.
Amount Probability $3,000 .30 4,000 .30 5,200 .40
The discount rate is 10%.
Required:
a. How should the asset be valued according to SFAC No. 7?
b. What other valuation is possible?
c. Which valuation do you prefer?
Part 2. Donahoe Company has a liability of $10,000 which is due in three years. The discount rate applicable to the firm is 10%. Assume that the firm’s credit standing is adversely affected by an untoward economic event. As a result, the discount rate applicable to the firm goes up to 12%.
Required:
a. How does the value of the liability change?
b. If the firm’s financial condition worsens, does it make sense for the value of the liabilities to decline? Explain.