A company with no interest-bearing debt enters into a capital lease on the first day of the reporting year. The lease requires a year-end payment of $175,000 for 10 years. In the second year of the lease, the company reported EBIT of $450,000. Assuming a 7% imputed interest rate on the lease, the firm’s interest coverage ratio in the second year is closest to: 4.3x 5.1x 5.6x 6.7x I have gone through this one so many times–I can duplicate but for the life of me cannot logically think through this one right now. Thanks

Let me try. We calculate the PV of the 175K payments We use that as the Initial Leasehold Value to start. Use 7% on that to calc interest exp for first year. Int Exp + Begin LH Value - Int payment = Ending LH value repeat for two periods. Answer seems to be 5.1x Care to confirm?

can u actually put the numbers here as I am confused by this example as well. thx in advance…

I’ll take a crack. We need to calculate the interest expense that the capital lease incurs. First we must find the present value of the lease obligation. In your calculator, PMT = 175,000 N = 10, I/Y = 7, P/Y = 1, FV = 0, CPT PV = 1,229,126.77 (year end payments so make sure your calculator is in END mode) Now here’s a trick, we want the liability in the second year, so you can just change N to 9 and CPT PV PV = 1,140,165.64, this is the lease liability at the beginning of the second year. Now, interest expense is the implicit lease rate * liability = 1,140,165.64*0.07 = 79,811.59 Int coverage ratio = EBIT / Interest expense = 450,000 / (79,811.59 ) = 5.6X is it C?

I think TheAliMan is correct. And he must be reading minds. I had accidentally left my calc in BGN mode !!

Thank you! Finally I understand it.

another way to do it (though Ali Man’s might be easier) get the PV of lease. multiply by the 7% interest rate so 1229126*.07 = 86,038 now take the lease payment minus the interest so 175000-86,038 = 88962. this is the amount of principal paid back and the deduction to the lease liability after year one. so new lease liability is 1,140,164. muliply this by .07 = 79,811.48 which is the interest expense in year 2. so 450000/79811.48 = 5.63

Okay, the answer is C, 5.6X Per the answer in the book: The present value of a lease payment with one annual payment of $175,000 at the end of the year over a 10-year period, discounted at 7% is $1,229.127. EOP Balance=BOP Balance (1+Interest Rate)-Lease Payment =1,229,127(1+0.07)-$175,000 =1,140,166 Interest during the second year of the lease is $1,140,166X0.07=$79,812 Interest Coverage EBIT/Interest which is $450,000/$79,812=5.64X

i found schweser questions a lot simpler than this… is this the level of difficulty the real exam could get?