4. KMC Inc. paid $16 million for the right to explore and extract coal from land

Question

4. KMC Inc. paid $16 million for the right to explore and extract coal from land owned by the state of Kentucky. To obtain the rights, KMC agreed to restore the land to a suitable condition for other uses after its exploration and extraction activities. KMC has a credit-adjusted risk free interest rate is 20%. It estimates the possible cash outflows for restoring the land, one year after its extraction activities begin, as follows: 50% at 10 million, 50% at 14 million. The asset retirement obligation should be recognized by KMC at the beginning of the extraction activities is: A. 10 million B. 12 million C. 14 million D. 16 million

Explanation / Answer

A$10 million.

probable cash outflow after one year = $10 million * 50% + $14 million *50%

=>$12 million

given,

credit adjusted risk free interest rate = 20% =>0.20.

=> the amount to be recognised = probable outflow / ( 1+ risk free rate)^n

here,

n = 1 year

=> amount = $12 million / ( 1.20)^1

=>$12 million / 1.20

=>$10 million

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