Schweser question: Management ofLLW Cabinetry, Inc., is considering leasing a new saw that will greatly increase the plant’s throughput. Information on the machine and the terms of the lease are as follows: • The machine has a fair market value of $2.8 million, an estimated 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 10.0%. • 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 machine (Note: carry calculations to at least three 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 $41,567. D. in the first month, cash flow from operations will decrease by approximately $21,039. Ans : D How?
ok, i’ll take a shot. 1st we need to determine if it is a capital or operating lease. Lease is less then 75% of useful life no bargain purchase option no transfer of title. check if PV of min lease payments is greater then 90% of fair market value. Bgn mode - (payments at beginning of month) Pmt 41567 i/y 10/12 n 7*12 = 2524723 which is just over 90% of FMV so lease must be capitalized. so CFO will be deducted by interest expense on the lease. 1st months interest expense is 2524723 * (.1/12) = 21,039
Whether it’s a Operating lease or capital lease, it still becomes a current and long term liability on the balance sheet, right?
No. If it is an operating lease, you expense it completely and it never hits the balance sheet. If it is a capital lease, you capitalize the asset and add the liability of the lease. This is a primary concept in accounting for leases - I would make sure to read over the material.
nevermind the operating lease doesn’t touch the balance sheet, only when the expense flows thru to RE and Net Income
When selecting the interest rate to use in the calculations: Company incremental borrowing rate is 11.5%. Implicit lease rate is 10.0% You chose 10% Do we always select the lower of the 2? If so, why?
You don’t always choose lower. If the company couldn’t determine the rate implicit by the lease (don’t know what the salvage value or buying price is for the lessor) then they would use their own incremental rate.
yea, because it increases the chance capitalizing the lease
correct Hoffmag but if 2 rates are given u choose the smallest of the 2.
what do you mean by increasing the chance of capitalizing the lease? I’m sure not all companies wants to capitalize lease right? Somewhere in my mind i rememebr schweser say that we use the lower value. but icant remmebr why
Most companies want to capitalize leases than treat them as operating leases. Doesn’t say exactly why in my text, just says it increases the chance of treating the lease as a capital lease and u should use that rate on the test
A capital lease would show higher CFO, that’s why companies would prefer a capital lease.
OKOK the lower rate it is