Techtronics, a technology company that uses IFRS for its financial reporting, ha

Question

Techtronics, a technology company that uses IFRS for its financial reporting, has been found to have polluted the property surrounding its plant. The property is leased for 12 years and Techtronics has agreed that when the lease expires, the pollution will be remediated before transfer back to its owner. The lease has a renewal option for another 8 years. If this option is exercised, the cleanup will be done at the end of the renewal period. There is a 70% chance that the lease will not be renewed and the cleanup will cost $240,000. There is 30% chance that the lease will be renewed and the cleanup costs will be $500,000 at the end of the 20 years. If you assume that these estimates are derived from best estimates of likely outcomes and the risk-free rate is 5%, the expected present value of the cleanup provision is:

A) $302,100

B) $318,000

C) $150,083

D) $370,000

Explanation / Answer

If the lease is renewed,

Present value of cleanup cost = $240,000 / 1.0512 = $240,000 * 0.5568 = $133,632

If the lease is not renewed,

Present value of cleanup cost = $500,000 / 1.0520 = $500,000 * 0.3769 = $188,450

Expected present value of cleanup provision = ($133,632 * 70%) + ($188,450 * 30%) = $150,077.40

Hence, answer is C) $150,083

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