Question
Dance Arts Center buys Dance Warehouse for $400,000. Both dance companies agree that if revenues of Dance Warehouse exceed $2,500,000 in the year following the
Dance Arts Center buys Dance Warehouse for $400,000. Both dance companies agree that if revenues of Dance Warehouse exceed $2,500,000 in the year following the acquisition date, Dance Arts Center will pay $50,000 to the former owners of Dance Warehouse. Assume the probability of revenues the next year are: $2,000,000 - 10%; $2,250,000 - 15%; $2,500,000 - 15%; $2,750,000 - 40%; and $3,000,000 - 20%.
Dance Arts Center should classify the arrangement as a liability because it requires Dance Arts Center to pay cash. How should the fair value of the liability be calculated based on this arrangement? Discuss risks involved.
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