On January 1, 2011, Barry Smith established a company by contributing $90,000 and using all of the cash to purchase an apartment house. At the time, he estimated that cash inflows due to rentals would be $65,000 per year, while annual cash outflows to manage and maintain it would be $45,000. He felt that the apartment house had a ten-year life and could be sold at the end of that time for $40,000. He also estimated that the effective interest rate during the ten-year period would be 10 percent. (This problem requires knowledge of present value. Refer to Appendix A.)
REQUIRED:
a. What is the book value of the building as of January 1, 2011? Assuming that Barry's estimates are correct, what is the economic value of the building? In your opinion, did Barry make a wise investment?
b. On December 31, 2011, Barry prepares financial statements and observes that his estimates were exactly correct. Assuming that cash inflows equal revenues, cash outflows equal expenses, and the net cost of the apartment, $50,000 ($90,000 - $40,000), is depreciated evenly over the ten-year period, prepare the income statement and balance sheet for Barry's apartment house.
c. Calculate the economic income of the apartment building for 2011. Economic income equals the difference between the present value at the beginning of the year and the present value at the end of the year plus any cash received during the year. Why is there a difference between accounting income and economic income?
d. What is the value on Barry's books of the apartment building at the end of 2011? What is the present value of the apartment building at that time?