Hello,
Year end annual lease payment = $175,000
EBIT in the next year = $450,000
7 percent imputed interest rate on the lease with a 10 year time period.
What is the interest coverage ratio?
Use your calculator to get the PV on the lease.
Calculate the interest on that PV.
Divide EBIT by that interest.
Arrive at 5.23.
To clarify 2000’s example - remember that on a capital lease, the interest expense is the carrying value at the beginning of the year times the interest rate. And the carrying value will be the lower of fair market value or the present value of the remaining payments.
In this case, since we don’t have FMV, we assume carrying value is the PV of the lease payments.
It says the answer is 5.6.
They computed the PV after the first period as PV in t = 0, then multiplied this by 1.07% and subtracted off 175,000 to arrive at 1,140,166.
You find the interest amount from this remaining PV after the first period and this divides the 450,000 to get 5.6 for the interest coverage ratio.
I think, we are supposed to compute the Interest coverage ratio for the 2nd year. Because we are provided EBIT for next year and judging from the solution keep_running provided, it sounds like they are computing the interest amount for the 2nd year after we make one payment in this period.
Yep, realized it was my mistake and should have stated that initially.
Apologies…