Voluntary assignment 1: Hick's income, due on Friday 15.1.2021 at noon (12:00)

See the below link on accounting under ideal conditions (durations appr. six minutes):

https://aalto.cloud.panopto.eu/Panopto/Pages/Viewer.aspx?id=fc0adcde-1476-4fc5-92cd-acaf007feb38

Solve the following problem

Ideal & Co. operates under ideal conditions of uncertainty. It has decided to purchase a new machine, but the management does not know how much to pay for the machine. The payment will take place at the beginning of the first year. The interest rate in the economy is 5 % p.a. The machine is expected to last for two years, after which time it will have zero salvage value.

The new machine is an experimental model, and its suitability for use in Ideal’s operations is not completely known. 

The first year:

Ideal assesses a 0.20 probability that there will be a major machine failure during the first year of operations, and a 0.80 probability that the machine will operate without a failure. If there is a major failure, cash flow for the year will be €2 000. If the machine operates without a failure, cash flow will be €4 000 for the year.

The second year:

If there is no major failure in the first year, the probability of a major failure in the second year is 0.70. If there is a major failure in the first year, the probability of a new major failure in the second year is 0.10. If there is a major failure in the second year, cash flow for the year will be €2 000. Cash flow for the second year will be €4 000 in case of no major failure in the second year.

It turns out that there is a major failure in the first year.

a) Assess what is an appropriate purchase price, provide calculations.

b) Prepare an income statement for year 1 and the balance sheet at the end of year 1 considering the major failure during the first year.