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My question quoted from BPP Practice & Revision Kit as below:-
In five years’ time Rainbird Co will have to dismantle its factory and return the site to the local authority. A provision was set up for the present value of the dismantling costs when the factory was first acquired. The opening balance on the provision at 1 Jan 20X1 was $2.63 million Rainbird Co has a cost of capital of 8%.The kit asks me “What is the amount of the provision that should be carried forward at 31 Dec 20X1 for the dismantling of the factory?
I would like to know why the calculation is $2,630,000 * 108% = $2,840,000 instead of $2,630,000 *1/1.08 = $2,435,185?
Hello Catherine,
So the question shows that the provision was made 5years prior to the dismantling happening thus the figure 2.63m given at Jan 1 20×1 is a discounted figure from the main expense due in 5 years time.Every PV is usually lower than the main value and as the year passes, that value increases (compound interest) until it matches the main value in the estimated year thus the 2,630,000 should now be multiplied by the cost of capital to get the interest accrued on the previous PV which added together will give the new value at Dec 31, 20X1 (it’s compounded ie compound interest) which is 1 year later. So 2,630,000 x1.08 = 2,840,400.
Remember,the present value of the final cost is supposed to increase as the year inches towards the estimated number of years.
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