another vague question from schweser,
Scooter has leased equipment for a period of 10 years with the following provisions:
*Lease payments $5,000 per year
*Current value of equipment $45,000
*Estimated useful life of equipment 15 years
*Salvage value no salvage value after 15 years
At the end of ten years, Scooter has the option to buy the equipment for $15,000. The discount rate is 10 percent. Scooter should:
A) capitalize this lease because the present value of the lease payments exceeds 90% of its fair market value.
B) treat this lease as an operating lease.
C) capitalize this lease because the lease term is less than 75% of the economic life of the equipment.
D) capitalize this lease because it involves a bargain purchase.
Your answer: D was incorrect. The correct answer was B) treat this lease as an operating lease.
Criterion Qualify as a capital lease?
The title is transferred to the leassee at the end of the lease period: No
A bargain purchase option exists: No
The lease period is at least 75 percent of the asset’s life: No
The present value of the lease payments is at least 90% of the fair value of the asset: No
PV = $30,723 < 90% of $45,000 = $40,500
My question is, how do we quantify a “bargain purchase option”? In this case, the purchase option is for 15000, which has a PV of 5783 (and the PV of the MLPs is 30723 as given above, giving a total of 36506, and the PV of the asset is 45000), so this does not qualify as a bargain purchase price? Is there any general rule of thumb for determining if a specific price is a bargain? Or is it because the question didn’t specifically say this option was a bargain purchase option, so it’s not one?….