Question

At the beginning of 2018, VHF Industries acquired a equipment with a fair value of $6,774,420 by issuing a four-year, noninterest-bearing note in the face amount of $8 million. The note is payable in four annual installments of $2 million at the end of each year. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

Required:

1. What is the effective rate of interest implicit in the agreement?
2. to 4. Prepare the necessary journal entry.
5. Suppose the market value of the equipment was unknown at the time of purchase, but the market rate of interest for notes of similar risk was 12%. Prepare the journal entry to record the purchase of the equipment.

Answer 1

Solution:

Face value of non interest bearing note = $8,000,000

Fair value of equipment = $6,774,420

Let implicit interest rate = i

Now present value of note discounted at i = $6,774,420

$2,000,000 * Cumulative PV Factor at i for 4 periods = $6,774,420

Cumulative PV Factor at i for 4 periods = 3.38721

Refer PV Factor table, This PV factor falls at i = 7%

Therefore effective interest rate = 7%

Solution 2 to 4:

Journal Entries - VHF Industries
Date	Particulars	Debit	Credit
1-Jan-18	Equipment Dr	$6,774,420.00
	To Notes Payable		$6,774,420.00
	(To record purchase of equipment)
31-Dec-18	Notes Payable Dr	$1,525,791.00
	Interest expense Dr ($6,774,420*7%)	$474,209.00
	To Cash		$2,000,000.00
	(To record interst expense and installment payment of note)
31-Dec-19	Notes Payable Dr	$1,632,596.00
	Interest expense Dr [($6,774,420 - $1,525,791)*7%)	$367,404.00
	To Cash		$2,000,000.00
	(To record interst expense and installment payment of note)

Solution 5:

Fair value of equipment = Present value of installment discounted at 12%

= $2,000,000 * Cumulative PV Factor at 12% for 4 periods

= $2,000,000 * 3.037349

= $6,074,699

Journal Entries - VHF Industries
Date	Particulars	Debit	Credit
1-Jan-18	Equipment Dr	$6,074,699.00
	To Notes Payable		$6,074,699.00
	(To record purchase of equipment)