Question

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.

Answer 1

Answer:

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