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17 November, 09:20

Montana Mining Co. (MMC) paid $200 million for the right to explore and extract rare metals from land owned by the state of Montana. To obtain the rights, MMC agreed to restore the land to a suitable condition for other uses after its exploration and extraction activities. MMC incurred exploration and development costs of $60 million on the project.

MMC has a credit-adjusted risk free interest rate is 7%. It estimates the possible cash flows for restoring the land, three years after its extraction activities begin, as follows:

Cash Outflow Probability

$10 million 60%

$30 million 40%

The asset retirement obligation (rounded) that should be recognized by MMC at the beginning of the extraction activities is:

a. $ 8.2 million.

b. $14.7 million.

c. $ 18 million.

d. $ 30 million.

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Answers (1)
  1. 17 November, 09:36
    0
    b. $14.7 million

    Explanation:

    In order to compute the asset retirement obligation, first we have to compute the expected cash flows which are shown below:

    = Cash outflows * probability + Cash outflows * probability

    = $10 million * 60% + $30 million * 40%

    = $6 million + $12 million

    = $18 million

    Now the asset retirement obligation would be

    = (Expected cash flows) : (1 + interest rate) ^ number of years

    = ($18 million) : (1 + 0.07) ^3 years

    = ($18 million) : 1.225043

    = $14.7 million
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