Acct. 414 – Fall 2006SOLUTION

Lease Example #4a

On 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 lessor
11.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 due
PMT = 46,836 (on calculator)

Decision process:

1 No title transfer

2 Purchase option = $2,500

Is 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 2006SOLUTION

Lease 4b - What if the lessor’s implicit rate is NOT known to lessee? Find the PVMLP.

N=3 (annuity due)

i=12%

Pmt=46,836

FV=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 4c

Computations using Excel

n / Lease 4
FMV = / 130,000
117,000 / 90% FMV
3 / Lease Term
5 / Economic Life
60.00% / LT as % Eco. Life
MLP Lessee / Comments
0 / 46,836
1 / 46,836
2 / 46,836
3 / 2,500 / BPO
4
10.00% / Lessee's discount rate
A / 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 / BPO
4
10.00% / Guess
C / 10.000% / Implicit Rate
MLP Lessor / Comments
0 / 46,836
1 / 46,836
2 / 46,836
3 / 2,500 / BPO
4
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 uncertainties

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

Lease #4dAmortization Table – Lessor

Date / Payment / Interest / Principal / Balance
1/01/12 / 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 BPO

LESSOR

1/2/2012
Net Lease Receivable $ 83,164
Cash 46,836
Sales $130,000

COGS $100,000
Inventory $100,000

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

1/2/2005 – at end of lease – receipt of BPO
Cash $ 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)

1/2/2012
Equipment (PVMLP) $130,000
Lease Liability. $ 83,164
Cash 46,836

12/31/12 (Use 5 year life)

Depreciation Expense $ 26,000
Acc'd. Depreciation $ 26,000

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

1/2/2005 at end of lease – payment of BPO

Lease Liability $ 2,500
Cash $ 2,500