Valuation using present value methods*

(1) Valuation of bonds at issuance Company X raises A20 million in cash by issuing five-year 5% bonds to investors on 2 January x1.

(Bonds are interest-bearing securities with, in most cases, a stated maturity date.) The company will pay interest annually in the amount of 1 million euros at the end of each of the five years x1 to x5.

The principal of the bonds (A20 million) will be paid in full on 31 December x5.

Required What is the present value of the bonds, at time of issuance, if the market rate of interest for bonds of equivalent risk at that date is:

(a) 5%?

(b) 6%?

(2) Valuation of leased equipment and effect on accounts Company Y is considering leasing computer equipment. The annual lease payment is A100,000 which the company must pay at the start of each year of the lease contract. The term of the lease is four years, which is also the expected economic life of the equipment. If the company buys the equipment with debt, the annual cost of borrowing will be 8%.

Required

(a) What is the present value of the lease payments under this contract?

(b) Assume the present value of the lease payments represents the market value of the computer equipment at the date the lease contract is signed (and the first payment is made). If Company Y is viewed as the economic owner of the computer equipment (because it will enjoy the economic benefits the equipment is expected to provide), how do you think Company Y should report the lease in its financial statements at the contract date?

(3) Calculation of pension contribution Company Z wants to set up a pension scheme for its current president that will give her (and her surviving spouse) an annual income of A250,000 for 20 years, starting when she retires in five years’

time. She will receive her pension at the end of each year. To ensure there are sufficient assets available to meet these payments, the company plans to make annual contributions to its pension fund over the next five years. Assume the annual discount rate used by the pension fund to discount its liabilities and the expected annual rate of return on fund investments are both 6%.

Required

(a) How much should the company contribute each year to the fund during the president’s remaining working life? Assume the annual contribution is made at the end of the year.

(b) How do you think the company and the pension fund should record the annual contribution to the fund?

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