I feel silly because this is supposed to be a “basic” question but I don’t quite get why the answer is what it is. Maybe this means I just need a break but can someone work through the problem and explain why you calculated it that way? Qbank 87570 Millennium Airlines Corp. (MAC) reported the following year-end data: Rent expense $23 million Depreciation expense $17 million EBIT $88 million Interest expense $22 million Total assets $500 million Long-term debt $150 million Capital lease obligations $100 million Total equity $250 million MAC also reported that the present value of its operating leases at the beginning of the year was $240 million. The term on the leases was 8 years. What are the effects on the leverage (liabilities / total capital) and times interest earned if an analyst chooses to capitalize the leases at a rate of 10% using a straight-line depreciation assumption? Leverage measures: A) increase to 65% from 50% and times interest earned decreases to 1.33 times from 4 times. B) remain unchanged and times interest earned decreases to 1.23 times from 4 times. C) increase to 65% from 50% and times interest earned decreases to 1.76 times from 4 times.
Old EBIT / Int = 88/22 = 4 New: To old EBIT: Add back 17 (depr) + Rent Expense (23) = 128 (reach back at EBITDA) Remove new Depr = 17 + 30 (240/8) = 47 New EBIT: = 128 - 47 = 81 New Int Exp: = Old Int Exp + 240 * 10% = 22 + 24 = 46 New EBIT/Int = 81/46 = 1.76 Old Leverage: (150 + 100)/ 500 = .5 You are capitalizing the Lease. So Assets = 500 + 210 = 710 (210 = 240 - Accum Depr of 30) PV of lease payments = 240 N=8 years I/Y = 10% Gives you PMT per period for Capital lease = 45 Mill. This is a combination of Principal + Interest. Interest = 240 * 10% = 24 So Principal payment = 21 (Current portion of Capital lease = Current Liability). So Long Term liab = 240 - 21 = 219 Million So total Long term liab : 219 + 150 + 100 = 469 LTD/E = 469/710 = .66 so choice C is your best bet… Schweser I believe solves it a little differently. Ans C As regards the A=L+E equation - you do not have enough info here - but the NI that flows in to the RE portion would be reduced now because of the higher interest and depreciation expenses… not enough info to solve the whole thing…
I was able to answer the first piece correctly but the way they got to the times interest earned is what bothers me. Shouldn’t the rent expense already be included in EBIT?
yeah - that relates to the lease rent - bcos it is an operating lease. so you now are considering it to be a capital lease. there would be no more rent expense. that would be replaced by the interest expense and depr. expense… that is what you are doing there. going back up to EBITDA, taking out the new Depreciation expense (old + new) to get to the new EBIT.
Gotcha… thanks!!