Chapter 8 - Solution Manual

Furthermore if we were to purchase an identical

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Furthermore, if we were to purchase an identical adjacent site that does not have a service station on it, the current site would not be more valuable than the adjacent site. Since both sites could be used to generate the same future cash flows and profit, one is not more valuable than the other. As a result, if we were to capitalize the costs of removing the tanks and refining the soil, we contend that the historical cost of the land would be overstated. Is not the initial value of an asset equivalent to the present value of the future cash flows expected from its use ? With regard to the capitalization of the $22,000 of “so called” avoidable interest that is incurred during construction, we can make similar arguments. It does not add to the future service potential of the building because it has no impact on the future cash flows or profit expected from the building’s use and thus does not add to its value. Moreover, the source of financing has nothing to do with the cost or value of the asset itself. Modern finance theory would separate the two. What would make a building financed with debt more valuable than a building that was financed with equity? Nothing would. If Entre financed the building with equity it would produce the same future cash flows as it would if he financed it with debt. Moreover, we could argue that the cost of financing with equity is potentially more expensive than the cost of financing with debt. Due to the riskiness associated with uncertain returns to investors, the return on an equity investment is generally higher than the company’s incremental borrowing rate. We argue that if capitalization of avoidable interest should be added to the cost of the asset, then so should the avoidable cost of capital that is effectively incurred when financing the construction with equity. WWW Case 8-11 The gross method of recording inventory is easy to apply. Purchases are recorded at the gross price. When a discount is taken, it is recorded as discounts taken. However, at the end of the accounting period, net purchases will be overstated unless adjusted for discounts that are expected not to be taken. Also, this method does not take into consideration that the discount theoretically represents interest on the net amount borrowed. Finally, the method does not highlight the cost of not taking discounts. The net method is also easy to apply. Purchases are recorded net of the discount. The theoretical justification is that discounts not taken are due to the passage of time and hence are more like interest on borrowed funds. The net method treats discounts not taken as interest expense. Also, the net method allows for better management control by reporting the cost of borrowing (the discount lost) separately.
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