Acct. 414 – Fall 2006 SOLUTION

Lease Example #4aOn January 1, 2012, Powell Trucking and Cummingham Diesel sign a lease with the following terms:

1. Term: 3 years 2. Payments of $________________ 3. Implicit interest rate (known to lessee) 10% 4. Est. fair value of asset at end of lease $2,500 5. Fair value of asset $130,000 6. Cost of asset $100,000 7. Incremental borrowing rate: 12% 8. First payment due 1/1/12 (at inception) 9. Estimated useful life of asset: 5 years 10. No collection or cost uncertainties for lessor11. Purchase option at end of lease: $2,500

Determine the payment that the lessor should request:

Lease 4a – involves finding the payment that a lessor should charge when they will get the asset back from lessee at end of the lease. The value of the returned asset is called the “unguaranteed residual value” if there is no specific guarantee of the value of the asset.

To find the payment – points to remember: a. Use lessor’s implicit rate,b. Must decide whether the lessee will exercise the purchase option (asset is not returned) or if the asset will be returned to the lessor (residual value)

Using financial calculator:N=3, i=10%, PV= -130,000 (always FMV and not cost of asset), FV=2,500 (not a BPO but asset will be returned at end of lease since there is no title transfer and no BPO), solve for PMT – annuity duePMT = 46,836 (on calculator)

Decision process:1 No title transfer

2 Purchase option = $2,500Is this a bargain? NO because it is only projected to be worth $2500 at end of lease

3 LT = 3/5 = 60% of economic life

4 90% of FMV = $117,000. Find PVMLP – lessee and lessor use same interest rate since 10% is less than 12%:PVMLP = 128,122 [n=3, i=10%, pmt=46,836, FV=0, annuity due (BGN)] Therefore capital lease for lessee

FOR LESSOR – must compute PVMLP since no TT, BPO, and LT=60%N=3, i=10%, PMT=46,836, FV=0(not a bargain), PVMLP=$128,122.No collection or cost uncertainties for lessor (item 10)There is a dealer’s profit (difference between item 5 and item 6

THEREFORE: Sales type lease for lessor[Note that PVMLP is same for lessee and lessor even though they are using the same interest rate – the reason is the unguaranteed residual value of $2,500 which is NEVER part of the MLP even though UnGRV must be considered when the lessor sets the lease payments]

Acct. 414 – Fall 2006 SOLUTION

Lease 4b - What if the lessor’s implicit rate is NOT known to lessee? Find the PVMLP.N=3 (annuity due)i=12%Pmt=46,836FV=0 (purchase option is not a bargain)PVMLP=125,991 (with calculator)Still capital lease because >90% of 130,000 = $117,000

What if lessee says their incremental borrowing rate is 20%?Still a capital lease (PVMLP=$118,391) – but for a lease with a longer life, a higher interest rate MIGHT cause the PVMLP test to fail even though the LESSOR met the 90% rule!

Lease 4cComputations using Excel

n Lease 4  FMV = 130,000   117,000 90% FMV  3 Lease Term  5 Economic Life  60.00% LT as % Eco. LifeMLP Lessee Comments

0 46,836  1 46,836  2 46,836  3 2,500 BPO4    

  10.00% Lessee's discount rateA Lessee's PVMLP:    130,000 Annuity Due  Lease 4 Type of Lease:B FOR LESSEE: Why?  Capital BPO     

 Lessor Cash Flows Comments

0 (83,164)  1 46,836  2 46,836  3 2,500 BPO4    

  10.00% GuessC 10.000% Implicit RateMLP Lessor Comments

0 46,836  1 46,836  2 46,836  3 2,500 BPO4    

D Lessor's PVMLP =  130,000 Annuity Due  Lease 4 Type of Lease:E FOR LESSOR: Why?  Sales Type BPO    Profit, no cost or

collection uncertaintiesPRACTICE VARIATION – same as 4c but lessee knows the implicit interest rate.

Lease #4d Amortization Table – Lessor Date Payment Interest Principal Balance1/01/12 130,000 1/01/12 46,836 0 46,836 83,164 1/01/13 46,836 8,316 38,520 44,644 1/01/14 46,836 4,464 42,372 2,273 1/01/15 2,500 227 2,273 0

143,008 13,008 130,000 0

Sales Type with BPOLESSOR1/2/2012Net Lease Receivable $ 83,164Cash 46,836

Sales $130,000

COGS $100,000Inventory $100,000

12/31/12Net Lease Receivable $ 8,316

Interest Revenue $ 8,316

1/2/2005 – at end of lease – receipt of BPOCash $ 2,500

Net Lease Receivable $ 2,500

LESSEE – assumes the lessee knows the implicit interest rate and is therefore using the same amortization table as the lessor (see above)1/2/2012Equipment (PVMLP) $130,000

Lease Liability. $ 83,164Cash 46,836

12/31/12 (Use 5 year life)Depreciation Expense $ 26,000

Acc'd. Depreciation $ 26,000

Interest Expense $ 8,316Lease Liability. $ 8,316

1/2/2005 at end of lease – payment of BPOLease Liability $ 2,500

Cash $ 2,500