which is also the fair value is calculated as follows with each cash flow occurring 566869

Nordstrom lends $1 million to Worldwide Retailers Inc. (Worldwide). The terms of the loan call for Worldwide to pay Nordstrom $130,000 at the end of each of the next five years and an additional $655,000 at the end of the fifth year. The total amount of cash that Worldwide will pay Nordstrom is $1.305 million [_ ($130,000 _ 5) _ $655,000]. The present value of the future cash inflows to Nordstrom associated with this loan differs as the discount rate changes. If the discount rate is the rate that a market participant would demand in an arm’s length lending arrangement, the present value is an estimate of the fair value of the loan. For example, if that rate is 7%, the present value, which is also the fair value, is calculated as follows (with each cash flow occurring at the end of the year indicated, amounts in millions):

The sum of these discounted future cash flows is $1 million (after rounding). From a business perspective, Nordstrom is lending $1 million with the expectation that it will receive both the principal of $1 million and an annual return of 7%. Nordstrom expects to receive a total undiscountedcash inflow from Worldwide of $1.305 million (5 [$130 3 5] 1 $655); these undiscounted cash inflows include both principal and interest at 7%. Other techniques for estimating the fair value of assets go beyond the scope of this textbook. We can use the discounted cash flow technique to illustrate the problems that the firm must solve to estimate a fair value in the absence of an observable market price. First, the firm identifies the amounts of future cash flows. In the loan example, there is no uncertainty about the cash flows, but as a practical matter, the future cash flows associated with an asset may depend on numerous factors, including technological innovation, product introductions by competitors, and inflation rates to name but a few. Even in the example of the loan with contractually specified cash flows, there is some possibility that Worldwide will default (that is, not make the promised payments). In a fair value measurement, Nordstrom would use a market participant perspective to estimate the probability of default. Second, the firm selects the appropriate rate to discount the future cash flows to the present.

To provide an estimate of the asset’s fair value, the discount rate should be the rate that market participants would use, reflecting current economic conditions including, for example, expectations of inflation and any uncertainty about the cash flows of the asset. We discuss fair value measurement more fully in Chapter 10.

Asset recognition and measurement. The transactions listed below relate to Polo Ralph Lauren (“Polo”). For each, indicate whether the transaction immediately gives rise to an asset for Polo and, if so, state the account title and amount Polo will record.

a. Polo spends $16 million to advertise a new line of perfume in the expectation that the advertisements will attract new customers.

b. Polo signs a contract with Nordstrom for the distribution of its fall line of clothes. Polo promises to distribute certain jeans exclusively through Nordstrom, and Nordstrom promises to display and market the jeans in a manner designed to increase sales. Polo estimates the fair value of the contract to be $4 million.

c. Polo invests $24 million in research and development related to its paint line of business.

d. Polo spends $800,000 on tuition assistance programs for its middle level managers to obtain MBAs. Historically, 80% of the managers who seek MBAs receive them and remain with the company five years or more.

e. Polo acquires and occupies a warehouse outside of Seattle by signing a mortgage payable for $75 million. Legal title for the warehouse remains with the bank (the holder of the mortgage) because Polo has not completed all required payments under the mortgage. Solutions to self study problems appear at the end of the chapter.