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Hi,
Actually, I just wanted to know about this doubt.
Why do we calculate PV of future cash payment in defer consideration?
For example, P co acquires S co on 1/1/X8 for share exchange and defer consideration.
Defer consideration payment to be made is $1980 @ 10% cost of capital for 1 year.(31/12/X8)So why don’t we calculate the interest on $1980?
Since the seller was entitled to receive this amount today (1/1/X8) but the buyer defers it to a later date(31/12/X8).Workings =
Share exchange = XXX
defer consideration = $1980 + (1980 * (0.1)) = $2178Whats given in Bpp is they have found PV of future payment
$1980/1.1 = $1800Sorry for my poor grammar.
Because, the time value of money means that paying out $1980 in 1 year means you need less than $1980 now.
Imagine you have a bank account earning 10% interest and you need to pay me $1980 in one year. How much do you need now, in order to do that? You don’t need $1980 sitting in your account now, as the money will earn interest over the year. If the rate of interest is 10%, you only need $1800 now as it will grow to $1980 by the end of the year.
The same concept applies to deferred consideration. If the cost of capital is 10%, then effectively you only need $1800 now, as it will grow by 10% to $1980 in 1 year. Therefore the initial liability is set at $1800, and over the year we charge $180 to finance costs to have a liability of $1980 by the end of the year.
The seller was not entitled to the amount today – the fact that it was deferred for 1 year would be part of the negotiated deal. Therefore we are not paying interest on it to the seller. The cost of capital of the buyer has no relevance to the seller.
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