Levi Corporation is in the robotic pool vacuum business. The company’s shares trade on the TSX. In 2010 the company purchased specialized equipment for $1,150,000. The market value of the equipment at the time of the acquisition was $1,170,000. Due to the large capital investments that need to be made in specialized equipment Levi Corporation doesn’t have many competitors.
Management expects that the equipment will produce the following cash flows: $70,000 for the next 6 years, with a 30% chance that it could be $60,000 each year. Management expects that the residual value will be $40,000 in 6 years.
The risk adjusted rate is 8% and the risk free rate is 6%.
The carrying value of the equipment on December 31st, 2017 is $340,000.
At the end of each year the company needs to test the equipment value to determine if there is an impairment.
- Provide two alternatives on how the controller of the company can value the asset on the date of acquisition. Be sure to support your answer using the qualitative characteristics. Provide the benefits and any shortcoming of recording it one way versus the other. Provide your recommendation on how the controller of the company should have recorded the asset. (6 marks)
- Explain two models that the company could consider to fair value the asset at the end of each year and whether the company would be able to use each of these models and why or why not. Provide your recommendation on which model the company should use (6 marks)
- Calculate the fair value on Dec 31st, 2017 using the traditional approach (2 marks)
- Calculate the fair value on Dec 31st, 2017 using the expected cash flow approach (2 marks)
- Under either approach explain if there is an impairment and why or why not. (2 marks)
- Which approach would you recommend that the company use and why? (2 marks)