 # turning it up a notch...

Use the following data for a company leasing a machine with a capital lease: - the lease period is 10 years - the lease payments are \$2,980.59 at the end of each year - the firm will own the asset at the end of the lease term but the salvage value will be negligible - 8.5% is the firm’s incremental borrowing rate - 8% is the implicit rate If the company uses straight line depreciation, the first year’s reported lease expense is: A. \$2,635 B. \$2,980 C. \$3,200 D. \$3,600 Any suggestions on how to tackle this one?

Just PV the lease payments to get your initial asset and liability. The interest portion of the lease expense is just the implicit rate (because it is lower than the incremental borrowing rate). PV in this case in 20,000. At 8% the first years expense on the lease is 1600. Depreciation is simply 20,000/10 = 2000/year. So total expense on the income statement relating to the capital lease is 1600+2000=3600…D

yeap, D PV of lease is 20,000 expenses: 20*0.08+2=3.6

D. Because the company owns the asset at the end of the lease, it is a capital lease. The PV of the cash flows (N=10, PMT=2980.59, i=8,FV=0) is \$20,000 Interest Expense is \$20000*.08 = \$1600 Depreciation is 20000/10 = 2000

D is it. It looks I’ll be back in December :

Can someone give a good explanation of the implicit interest rate concept?

Whenever calculating the PV of a lease, use the minimum of implicit rate or cost of borrowing. A sort of financing from the lessor.

IRR of the loan payments to the cost of the asset from the lessor’s perspective.

The reason you use the lower of the implicit rate and firm’s incremental borrowing rate is because choosing the lower rate increases the PV of MLP - which in turn is more likely to meet the condition for categorising it as a capital lease (PV of MLP is at least 90% of the fair value of the asset.

That’s a good one! thanks