Peter La Fleur is the sole proprietor of La Fleur Enterprises. He is exploring t

Question

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 three situations, which the firm brings to Peter’s attention, are as follows:

a) La Fleur purchased the building in which their corporate office is housed on 1/1/10 for $7,800,000.   They put down $2,000,000 cash and had to borrow the remaining amount at 8% 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 1/1/10, and called for payments of $600,000 beginning on that date for the first 10 years and payments of $500,000 beginning on 1/1/20 for the remaining 10 years of the lease. La Fleur had the option to purchase the building for $1 on December 31, 2029 at the end of the lease. Did the CFO make the right decision by purchasing the building? Why or why not? Show your work. For the amortization schedules be sure to print the schedule so all columns fit on one page

b) This year, the company sold land for a non-interest bearing note. The note calls for annual payments of $10,000 for 4 years. The payments will begin one year from the date of the sale. An appropriate rate of interest for this type of note is 6%. The land had an original purchase cost of $25,000. The CFO told the accounting department to record the sale as follows: For the amortization schedules be sure to print the schedule so all columns fit on one page

Notes Receivable                   $40,000

            Land                                       $25,000

            Gain on Sale of Land             $15,000

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

c) The CFO has a policy of never taking cash discounts on goods purchased, as he believes he can invest the money at a higher rate of the return. The consultants argue that this is not always the case. As an example, they present to Mr. La Fleur the recent purchase of materials of $1,000,000 with terms 1/10, n/30. La Fleur estimates its cost of funds is around 6%. Should La Fleur continue not taking the discounts? Why or why not? Show your work. For the amortization schedules be sure to print the schedule so all columns fit on one page

Explanation / Answer

Part A)

We will have to calculate the present value of the future lease payments in order to arrive at a decision. The present value of lease payments can be calculated with the PV function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV,Type) where Rate = Interest Rate, Nper = Period, PMT = Payment, FV = Future Value (if any) and Type = 1 (as it is a case if annuity due).

__________

First we will determine the present value of $600,000 for 10 Years as follows:

Present Value of first 10 Payments = PV(8%,10,600000,0,1) = $4,348,132.75

Now, we will have to calculate the present value of remaining 10 payments and discount the present value to today's values as follows:

Present Value of Last 10 Payments = PV(8%,10,500000,0,1) = $3,623,443.96

Today's Value of Present Value of last 10 Payments = 3,623,443.96/(1+8%)^10 = $1,678,355.64

______

The total present value of lease obligation is calculated as follows:

Total Payment with Lease Option = 4,348,132.75 (Present Value of First 10 Lease Payments) + 1,678,355.64 (Present Value of Last 10 Lease Payments) = $6,026,488.39

No, the CFO has not made the right decision to purchase the building as the total present value of lease payments of $6,026,488.39 is less than the purchase price of $7,800,000. The company should have leased the building.

_________

Part B)

We will have to calculate the present value of 4 annual payments in order to correct the journal entry. The present value of annual payments can be calculated with the PV function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV) where Rate = Interest Rate, Nper = Period, PMT = Payment and FV = Future Value (if any)

______

Here, Rate = 6%,Nper = 4, PMT = $10,000 and FV = 0

Using these values in the above function for PV, we get,

Present Value of Annual Payments = PV(6%,4,10000,0) = $34,651.06 (today's value of land)

The correct journal entry is given below:

_________

Part C)

We will have to calculate the effective cost of trade credit and compare it with the company's rate of return on investments. The effective cost of trade credit can be calculated with the use of following formula:

Effective Cost of Trade Credit = (1+ Discount Percentage/(1-Discount Percentage)^(365/Days after Discount Period) - 1

Here, Discount Percentage = 1% and Days after Discount Percentage = 30 - 10 = 20

Using these values in the above formula for Effective Cost of Trade Credit, we get,

Effective Cost of Trade Credit = (1+1%/(1-1%))^(365/20) - 1= 20.13%

On comparing the effective cost of trade credit of 20.13% with the cost of funds of 6%, we can easily conclude that the company should start taking discounts as the return expected to be generated on investments is far below the cost of not obtaining the discount.

Accoun Titles Debit Credit Notes Receivable (Present Value) $34,651.06 Land $25,000 Gain on Sale of Land $9,651.06 (To recognize gain on sale of land)

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