 # Lease Question

Management of Caldor Kites, Inc., is considering leasing a new asset. Information on the asset and the terms of the lease are as follows: The asset has a fair market value of \$1.3 million, an estimated useful life of 7 years, and no salvage value. Company incremental borrowing rate is 13.0%. Lease term of 5 years with lease payments of \$24,700 due at the beginning of each month. Implicit lease rate is 10.0%. The lease does not contain a bargain purchase option and there is no title transfer at the end of the lease. If management leases the asset (Note: Carry calculations to at least 3 decimal places): A) the current ratio is unaffected (all else equal). B) the lease period is greater than 75% of the asset’s useful life. C) in the first month, cash flow from operations will decrease by approximately \$24,700. D) in the first month, cash flow from operations will decrease by approximately \$9,770.

D PV of lease, with the calculator in BGN mod (payments at beginning of each month), is N=5*12, I/Y=10/12, PMT=24,700, FV=0, cpt PV=1,172,202.24 that is 1,172,202.24/1,300,000=90.169% of the market value of the asset, this is a capital lease, for which the interest paid in the first month (1,172,202.24*10%/12=9,768) is CFO outflow

map1- There are 4 conditions for capital leasing. You are just getting one of them correct But other conditions like lease period should be greater than 75% of useful life and can be purchased at negotiated price are not getting satisfied Eventhough, will you claim to be capital lease? Won’t it be simple operation lease and C is correct answer?

only one of the criteria needs to be met

D is Correct. I like map’s style of digging this problem however here’s the Schweser’s answer. As shown below, the present value of the lease payments is slightly greater than 90% of the fair market value of the lease and thus the lease would meet the criteria for a capital lease. Cash flow from operations in the first month will be reduced by the present value of the lease payments (calculated below) times the discount rate (here the implicit lease rate). The trick here is to calculate the present value of the lease payments with your calculator in BEGIN mode since the lease payments are made at the beginning of the month. Set your calculator to begin mode. Then, FV = 0 (no salvage), N = 60 (use lease term of 5 years times 12 months), I/Y = 10.0 / 12 (use the lower of the incremental borrowing rate or implicit lease rate), and PMT = 24,700 Compute PV = -1,172,202.237 , or 90.169% of the fair market value of \$1,300,000. Thus, the lease meets one of the criteria for a capital lease. In the first month, cash flow from operations will decrease by 1,172,202.237 × 0.10 / 12, or approximately \$9,768. (Note: If you have your calculator in end mode, the computed PV is 1,162,514.615, or 89.424% of the fair market value.) Since the lease then would not meet any of the criteria for a capital lease (lessee), it would be booked as an operating lease and the entire lease payment would reduce cash flow from operations. The other statements are false. Since the lease should be capitalized, the current portion due will increase current liabilities and thus impact the current ratio. The lease period is less than 75% of the asset’s useful life (5 / 7 = 71.4%).