# Accounting Question...Interest Coverage Ratio

On January 1st, a company entered into a 10 year capital lease agreement that required an annual payment of \$150 000 at the end of each year. For the year ended 31 December 2004, the company reported earnings before interest and taxes of \$370 000. During 2004, the company has no interest bearing debt outstanding. If the appropriate lease related interest rate is 8 percent, the company’s interest coverage ratio was closest to: A) 3.1 B) 3.4 C) 4.6 D) 4.9 Apparently the Answer is D…The following explanation was provided: PV of lease payments on January 1st 2003: 1 006 512 Balance Remaining on January 1st 2004: 937 033 2004 Interest: \$74 963 Interest Coverage Ratio for 2004: \$370 000/ \$74 963= 4.94 So I understand how we got PV of \$1 006 512…N: 10 I/Y: 8 PMT: -150 000 F/V: 0 CPT PV= \$1 006 512…What I am wondering is how the 2004 ineterest is \$74 963?..When I use the amortization worksheet on the BAII plus I get \$80 520.97…when plugged into the interest coverage ratio: Ebit/Interest 370 000/80 520.97= 4.59 or Answer C Clearly I am doing something wrong being that the exact answer was strategically placed in the choices, can someone please clarify for me what I am doing incorrectly?..Even if I change N to 9 to find the pv balance after 1 year I get 937 033.18, which when subtracted from 1 006 512 = 69 478 as the principal payment in the first period 150 000-69 478.8 still equals 80 521 worth of interest???..Any advice would be greatly appreciated. Thanks in advance Dubs

I think the question pattern is missing the fact that this is the 2nd year of the lease. Given the above - we would assume lease started on Jan 1st 2004. From the way they have calculated it - it started in 2003, and now in 2004 it is a lower interest.

PV of lease payments on January 1st 2003 : \$1,006,512 2003 total payment : \$150,000 2003 interest payment (8% * 1,006,512) : \$80,520.97 2003 principal payment (150,000 - 80,520.97) : 69,479.03 Balance Remaining on January 1st 2004 : \$937,033 2004 interest payment (\$937,033 * 8%) : \$74,963 2004 Interest Coverage Ratio = EBIT / Interest Payment = \$370,000 / \$74,963 = 4.935

finance03 – where did the problem state that the lease was signed in 2003?

I recall this problem from one I have already completed, I am assuming that the poster either forgot to post the date, or the source he received it from took the original problem but forgot to add in the correct date!

My bad …I looked back at the question and it DOES state it started in Jan 2003…I wrote it out wrong…So can this be done using the amortization worksheet at all or is it all just straight plug and chug…?

you can solve with the Amort worksheet. Make sure period = 2. Instead of the 1 you have plugged in now, and you get the right answer – which is 4.9%.

cpk what do I change to 2 p1 or p2.?..when I leave p1 as 1 and change p2 to 2 I still seem to get the wrong answer…if you have a sec do mind quickly posting the steps to getting there. Thanks alot. Dubs

you can put both P1 and P2 to 2 to be safe.

alright I will give that a shot. thanks CPK