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 1.76 times from 4 times. B) increase to 65% from 50% and times interest earned decreases to 1.33 times from 4 times. C) remain unchanged and times interest earned decreases to 1.23 times from 4 times. Your answer: B was incorrect. The correct answer was A) increase to 65% from 50% and times interest earned decreases to 1.76 times from 4 times. Using the reported data the leverage measure is 0.50 ((150 + 100) / (150 + 100 + 250)) and times interest earned is 4 times (88 / 22). Following the capitalization of the operating leases the balance sheet values are: Total assets $710 million (500 assets + 240 leases - 30 depreciation on leases) WHY IS DEPRECIATION INCL HERE in the assets AND NOT JUST THE PV of cash flows added to A&L. Depreciation would be taken off at the END of the yr. The question doesn’t state what are total assets at yr end? Value of operating leases $210 million (increase in financing liabilities) Long-term debt $150 million unchanged Capital lease obligations $100 million unchanged Total equity $250 million unchanged Therefore, the leverage measure is 0.65 ((210 + 150 + 100) / (210 + 150 + 100 +250)). Again here the 210 is net of depreciation (240 - 30) - why is this? Surely it should be the PV of cash flows to liabilities only (ie 240) The income statement is affected in the following way: reported EBIT 88 + rent expense 23 = EBIT excluding cost of operating leases 111 - depreciation of operating leases 30 ($240 million/8 years) = adjusted EBIT 81 Here EBIT is lower under the capital lease - however below question states EBIT would be HIGHER under a cap lease?? Can anyone explain these conflicting answers? Interest expense will increase by $24 million ($240 million × 0.10) to $46 million. Therefore times interest earned decreases to 1.76 times (81 / 46). Recall that when capitalizing operating leases interest expense is calculated as the present value of the lease obligations multiplied by implied interest rate. As compared to an operating lease, which of the following best describes the impact of a capital lease on earnings before interest and taxes (EBIT) and operating cash flow (OCF) according to U.S. generally accepted accounting principles? EBIT OCF A) Lower Higher B) Higher Lower C) Higher Higher Your answer: A was incorrect. The correct answer was C) Higher Higher With an operating lease, rent expense is included in EBIT. In a capital lease, rent expense is replaced by depreciation expense and interest expense. Since EBIT is calculated before interest and taxes, EBIT is higher with a capital lease. In an operating lease, the rent payment is included in operating cash flow (previous question has adjusted EBIT as LOWER under a capital lease???). With a capital lease, the rent payment is replaced by principal and interest. Since principal payments are considered financing activities, operating cash flow is higher with a capital lease.
anyone got any idea on this…there is conflicting information on the depreciation and adjusted EBIT…?..Anyone…?
Where did you find the question? I would imagine that the depreciation on the capitalized lease is almost always higher than the savings from reduced rent payment. Therefore, I would assume EBIT to be generally lower when a lease is capitalized.
Both from Qbank - and as you say you thought adjusted EBIT would be lower, in the first question adjusted EBIT is lower (i have highlighted the EBIT part of the first question) The income statement is affected in the following way: reported EBIT 88 + rent expense (as now capitalised you dont pay the expense) 23 = EBIT excluding cost of operating leases 111 - depreciation of operating leases 30 ($240 million/8 years) = adjusted EBIT 81 however in the second question they say adjusted EBIT for capitalised leases is higher… ‘With an operating lease, rent expense is included in EBIT. In a capital lease, rent expense is replaced by depreciation expense and interest expense. Since EBIT is calculated before interest and taxes, EBIT is higher with a capital lease’ so now v confused.
this is level 1 dude…answer is C for the reasons stated. Op lease = rent expense Cap lease = Dep + Int EBIT is higher under cap lease
Billy big b@lls Thommo explain question 1 then…why is adjusted EBIT lower… Take current EBIT + Rent expense then remove depreciation…EBIT comes out lower…
I’d love to understand the crisp logic on that matter too. Especially since I just reviewed my L1 Secret Source and it confirmed the reasoning that a cap lease should have lower EBIT, at least in the early years. Since I value early payments more than later payments, I’d say EBIT is in general lower for cap lease.
ive sent it to schweser - will revert back if they answer. Also if anyone can enlighten me on the adjustment to Assets and Liabilities when dealing with a cap lease. To adjust for a cap lease, I assume soley the PV of the operating lease cashflows is added to both A&L at the outset…depreciation of the new cap lease IS NOT taken into account at the outset is it? In the above question they do take into account when calculating both ASSETS and LIABILITIES…
Here is schwesers response: 1). Depreciation should be taken into account when capitalizing a lease. Please refer to page 156 of Book 2 of the SchweserNotes. 2). EBIT should be greater under a capital lease than an operating lease. The result in Question 10 is a function of the numbers used to construct the question. The lessor would not lease out an asset for $23 million per year if the depreciation on the asset was $30 million per year.
Seemed like a bad question.