Question

1. Peter La Fleur is the sole proprietor of La Fleur Enterprises. He is exploring the option of going public because his company is growing exponentially. The consulting firm that is reviewing his financials has questioned whether La Fleur’s CFO is technically competent enough to be the CFO of a publically traded company, as they believe he made several bad financial decisions. The two situations, which the firm brings to Peter’s attention, are as follows:

1. La Fleur purchased the building in which their corporate office is housed on 1/1/16 for $4,500,000.   They put down $900,000 cash and had to borrow the remaining amount at 5% over a 20-year term. At the time of the purchase, they had the option to lease the building. The 20-year lease would begin on 1/1/16, and called for annual payments of $350,000 beginning on that date for the first 10 years and payments of $300,000 beginning on 1/1/26 for the remaining 10 years of the lease. La Fleur had the option to purchase the building for $1 on December 31, 2035 at the end of the lease. Did the CFO make the right decision by purchasing the building? Why or why not? Show your work.
2. This year, the company sold land for a non-interest bearing note. The note calls for annual payments of $20,000 for 5 years. The payments will begin one year from the date of the sale. An appropriate rate of interest for this type of note is 4%. The land had an original purchase cost of $90,000. The CFO told the accounting department to record the sale as follows:

Notes Receivable                   $100,000

            Land                                       $90,000

            Gain on Sale of Land             $ 10,000

            Was this entry correct? If not, provide the correct entry.

Answer 1

a) To arrive at a decision, we have to calculate present value of future lease payments. The formula for PV is

PV(Rte, Nper, PMT,FV,Type) where rate = interest rate

Nper = Period

PMT = Payment

FV = Future value

Type = 1 as it is annuity due

Present value of first 10 payments of $ 350,000 = PV(5%,10,350000,0,1) = $28,37,737.59

Present value of remaining 10 payments of $300,000 = PV(5%,10,300000,0,1) = $ 24,32,346.50

Todays value of present value of last 10 payments = 2432346.50/(1+5%)^10 = $ 14,93,249.76

Total payment with lease option = $ 28,37,737.59+ $ 14,93,249.76 = $ 43,30,987.35

No, The CFO has not made the right decision, as present value of lease option is less than the purchase price of the building of $ 4,500,000.

b) We have to calculate present value of 5 annual payments in order to correct the journal entry.

Here rate = 4%, Nper = 5, PMT = $20,000 and FV = 0

Present value of annual payments = PV(4%,5,20000,0) = $89036.45 (present value of land)

So the correct journal entry is

Notes receivable(present value) Dr $ 89,036.45

Loss on sale of land Dr $ 963.55

Land A/c Cr $ 90,000