 # Schweser question (is this even relevant? to the exam)

Management of LLW Cabinetry Inc is considering leasing a new saw thta will greatly increase the plant’s throughput. Information on the machine and the terms of the elase are as follows: The machine has a fair market value of \$2.8 million, an estimate useful life of ten years, and no salvage value. Company incremental borrowing rate is 11.5% Lease term of seven years with lease payments of \$41,567 due at the beginning of each month Implicit lease rate is 10% 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 machine A. the current ratio is unaffected 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 \$41,567 D. in the first month, cash flow from operations will decrease by approximately \$21,039

it seemed like it was an operating lease so the decrease in cfo would be the annual rental payment, so i chose C, answer key says it’s D though

it seemed like it was an operating lease so the decrease in cfo would be the annual rental payment, so i chose C, answer key says it’s D though I don’t remember seeing anything on Implicit lease rates in the CFA cirriculum or incrememntal borrowing rate…am i missing out on something??

YEs this tries to see if this is a capital lease or operating. In case MLP of 41567 exceeds 75% of fair value it will be a capital lease. I do not have a calculator on me so I cannot ans this question. In case MLP is less than 75% of fair value, it is an operating lease and CFO will be affected accordingly.

You are supposed to use the lower of the lesee’s incremental borrowing rate or the implicit rate. Answer is D.

PMT=41567 I/Y = 10/12 N=7*12=84 CMPT PV = 2,503,857.56 Since it’s an annuity due -> 2503857.56*1.008333 = 2,524,723.03 (You can avoid having to do this by switching to BGN mode) This is just over 90% of 2.8MM, so it is a Capital Lease. Int Exp = (0.10*2,524,723.03)/12 = 21,039.

It is 90% of fair value and 75% life of equipment … smeet - please note. Lease term is 7 years BGN mode, PV=? PMT=41567, N=84, I/Y=.83333 PV = 2524723 2524723/2800000 = 90.17% So it is a capital lease. (REMEMBER BEGIN VS. END MAKES THE DIFFERENCE IN THE SELECTION OF CL vs. OL). Now it is a capital lease --> So CFO for the first month = Interest payment = 2524723 * .0833 = 21031 Choice D

Ans is D since MLP= 2524723 which is greater than 75% of Fair value. THis is a capital lease.

Oh yes my mistake…

Smeet For a Lessee: Capital Lease: 90% of FV, 75% of asset life, Bargain Purchase Option, Item transfers to Lessee at the end of lease term. You are getting confused between 90% of FV and 75% of asset life above.

smeet Wrote: ------------------------------------------------------- > YEs this tries to see if this is a capital lease > or operating. In case MLP of 41567 exceeds 75% of > fair value it will be a capital lease. I do not > have a calculator on me so I cannot ans this > question. > > In case MLP is less than 75% of fair value, it is > an operating lease and CFO will be affected > accordingly. Its actually the preseent value of the MLPs must equal or exceed 90% of the fair value of leased property

Condition 1: 7/10 = 70% FAILS Condition 2: PMT = 41567 N = 7*12 = 84 I/Y = 10/12 = 0.8333 BGN CPT–> PV = 2524723.032 2524723.032/2800000 = 0.90168679 (Just made it… to the Capital Lease) therefore CFO is not rental payment, it’s the IE on book value CFO = IE* PV(MLP) = 2524723.032 * 0.8333 = 2103851.7025656 = D? - Dinesh S

sorry for the repeat

dinesh – .8333/100 above. and yes D is correct.

cpk123 Wrote: ------------------------------------------------------- > dinesh – .8333/100 above. > and yes D is correct. ohh…yes, thanks cpk, forgot to convert the % to decimal.