Question

At the beginning of 2021, VHF Industries acquired a machine with a fair value of $7,779,300 by issuing a five-year, noninterest-bearing note in the face amount of $10 million. The note is payable in five annual installments of $2 million at the end of each year.

REQUIREMENT:

1. What is the effective rate of interest implicit in the agreement? 2. Prepare necessary journal entry

2a. Record the purchase of the machine

2b. Record the first installment payment December 31, 2021

2c. Record the second installment payment at December 31, 2022

3. Suppose the market value of the machine was unknown at the time of purchase, but the market rate of interest for notes of similar risk was 9%. Prepare the journal entry to record the purchase of the machine

Answer 1

Solution 1:

Let effective interest rate implicit in agreement = i

Now at i present value of annual installment = Fair value of machine

Cumulative PV Factor at i for 5 periods = $7,779,300 / $2,000,000 = 3.88965

Refer PV factor table, this factor falls at i =9%

Therefore implicit interest rate in agreement = 9%

Solution 2:

Journal Entries - VHF Industries
Date	Particulars	Debit	Credit
1-Jan-21	Equipment Dr	$7,779,300.00
	To Notes Payable		$7,779,300.00
	(To record equipment purchased on issue of note)
31-Dec-21	Interest expense Dr ($7,779,300*9%)	$700,137.00
	Notes Payable Dr	$1,299,863.00
	To Cash		$2,000,000.00
	(To record installment payment)
31-Dec-22	Interest expense Dr [($7,779,300 - $1,299,863)*9%]	$583,149.00
	Notes Payable Dr	$1,416,851.00
	To Cash		$2,000,000.00
	(To record installment payment)

Solution 3:

Fair value of machine = $2,000,000 * Cumulative PV Factor at 9% for 5 periods

= $2,000,000 * 3.88965 = $7,779,300

Journal Entries - VHF Industries
Date	Particulars	Debit	Credit
1-Jan-21	Equipment Dr	$7,779,300.00
	To Notes Payable		$7,779,300.00
	(To record equipment purchased on issue of note)