capital lease question

CFA Level I
#1

You are currently reviewing the following information for JKL Corp.:

Starting date of lease: Jan 1st, 2002

Annual year-end lease payments: $32,000

Term of Lease: 5 years

Buy-back value at end of term: $55,000

Interest rate implicit on lease: 11%

Interest rate on company’s general debt: 13%

If the company uses the capitalized lease method of accounting, what would be the interest expense during the second year of the inception of the lease?

(a) $14,490 (b) $15,750 © $14,906

The correct answer is A. I keep ending up at C. Can someone please explain? Thanks

#2

I get C as well.

Do they have an explanation?

#3

Answer and question posted here: http://www.investopedia.com/professionals/questionoftheweek/cfa/062006.asp

#4

So the correct answer is $14,906, as we both got.

Apparently there was something wonky with the original answer choices given; they don’t match (in order) those given in FratBoy’s link.

#5

Is there an easier way besides building a table?

#6

Nope.

(Of course, here you really need only the first row of the table to get the balance at the end of year 1, then compute the interest on that. Nevertheless, it’s still a table.)

#7

Wow that is crazy. This was really driving me nuts, I was up half the night trying to figure it out. It said the answer was A and showed the math as

Interest Expense = (Book Value of Capitalized Lease at beginning of period) x (Effective Interest Rate)

$131,727 * 11% = $14,490

#8

Aside from building the table, couldn’t you just use the financial calculator to scroll through the amortization table to the second payment? I got the same answer doing this, and by finding the PV of the lease with 4 years remaining, then calculating interest off of the PV at the end of the first year (beginning second year).

FV= 55000

PMT= 32000

PV=?

I= 11%

N=4

—> PV*.11= interest in year 2

-OR-

Use the same inputs, except N=5, then use the amortization table for period 2.

#9

Yes you could definitely do either of those things as opposed to making a table. I used the amortization function in the financial calculator. It really pays to know how to use that thing.

#10

Wow, thanks. That was really helpful.

The more you know… laugh

#11

Good point.

#12

I took a real estate course and a financial statement analysis course, both of which helped me figure out these tricks from similar problem types. Glad I could help!

#13

I should have thought of that sooner: it’s so obvious.

Thanks again!