You are the CEO of Dry Bottoms Diaper Service, which provides cloth diaper deliv

Question

You are the CEO of Dry Bottoms Diaper Service, which provides cloth diaper delivery, pick up, and laundering. Your customer base consists of a small number of upper middle class and wealthy families who can afford the luxury of your service. However, as part of your 2016 strategic plan, you want to expand your customer base to include averaging middle class working families as well. After months of collaboration, your executive team proposes that on December 1st, 2015, you announce your 'New Years Baby" sweepstakes. The sweepstakes will provide three months of free diaper service AND a full college scholarship to the first baby born at Community General Hospital on January 1st, 2016. Based upon average tuition costs at public, non-profit universities within your state, you determine that in order to fund the full scholarship, you will need to have accumulated $112,000 at the end of 17 years. To do this, your CFO plans on depositing equal monthly amounts into a restricted trust account that pays 6.25% compounded interest annually.

(A) What is the monthly amount that will be deposited each month?

(B) What is the present value of $112,000 to be received 17 years from now, discounted back to the present at 6.25 percent?

(C) How would YOU elect to record the new $112,000 liability on your corporate financial reports (Balance Sheet, Income Statement, Statement of Cash Flows)?

Explanation / Answer

A) It is presumed that each of the monthly payments made will earn simple interest at 6.5%

Ie: the first instalment will earn simple interest at 6.5% pa, for 11 months, the second instalment for

10 months and so on. Compounding will be done at the year end.

So, each year the year end amount ie: instalments =+ simple interest would be = A*12 + A*6.5/1200*11+A*6.5/1200*10…………………….+A*6.5/1200*0

=A*12+A*0.00542*11(11+1)/2 =A*12+.35772A=12.35772A

Let the above 12.35772A = X

Then, we have 112,000 = X * CVIFA6.5, 17

The CVIFA for 6.5 for 17 years can be taken as the average of values for 7% and 6% = (28.213+30.840)/2

=29.5265.

X = 112000/29.5265=3793.20 $

Therefore, the monthly amount to be paid ie: A = 3793.20/12.35772= 306.998 Say $307

B) The PV of 112,000 discounted back at 6.25% = 112000*PVIF 6.25,17

     =112,000 * 0.36 = $ 40,320

C) In the Balance Sheet, the PV of the future obligation has to be shown as a long term liability.

    Hence, $ 40,320 will be shown as a liability in the balance sheet, by debit to Deferred Expense A/c,

    presuming that 6.25 (as given under B above) is the applicable rate.

    In the Income statement, the appropriate portion from the Deferred Expense A/c will be charged as

    expense.

    In the Cash Flow statement, only the investment of $ 307 per month or 307*12=3684 $ per annum

    will be shown as outflow, under investment activities.

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