QUESTION 27 Illustration 27–Determining the discount rate VT Limited enters into a contract with a customer to sell equipment. Control of the equipment transfers to the customer when the contract is signed. The price stated in the contract is $ 10 Million plus a 10% contractual rate of interest, payable in 60 monthly instalments of $ 212,470. Determine the discounting rate and the transaction price when Case A: Contractual discount rate reflects the rate in a separate financing transaction Case B: Contractual discount rate does not reflect the rate in a separate financing transaction i.e. 14%.

Solution

Case A: Contractual discount rate reflects the rate in a separate financing transaction

In this case, the contractual rate of interest (10%) can be considered the appropriate discount rate as it reflects the rate that would be used in a separate financing transaction.

In order to find the transaction price, we will calculate the present value of the 60 monthly payments of $212,470, discounted at the 10% annual rate, assuming it is an annual compound rate. If we assume monthly compounding, we should adjust the rate to its monthly equivalent.

Case B: Contractual discount rate does not reflect the rate in a separate financing transaction (i.e. 14%)

If the contractual rate of 10% does not reflect the rate that would be used in a separate financing transaction, we should use the discount rate that reflects that separate financing transaction rate. In this case, the 14% annual rate should be used.

Again, the transaction price would be calculated as the present value of the 60 monthly payments of $212,470, but now discounted at the 14% annual rate, again assuming annual compounding unless stated otherwise. For monthly compounding, we would need to adjust the rate to its monthly equivalent.

Remember, it's important to understand how the interest is compounded (annually, semi-annually, quarterly, monthly, etc.) to adjust the discount rate appropriately.

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