FIN 401 Lecture 3: Leasing

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20 Feb 2017

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Leasing analysis decides how to finance the assets: leasing vs. buying: an extension to the capital budgeting decision. Lease a contract between 2 parties where one party (the lessee) pays the other (the lessor) for use of an asset. The owner (lessor) gets the asset back at the end of the lease, unless otherwise specified. The lessee can sometimes lease directly from the manufacturer, who takes on the role of lessor. Sometimes, the lessee leases from a financing company, who purchases the asset from the manufacturer. Allow the lessee to use the leased property for only a portion of its economic life. Lessor is responsible for insurance, taxes and maintenance. Covers the majority of the entire economic life of the asset. Lessee is responsible for insurance, taxes and maintenance. All the risks and rewards of the leased property are transferred to the lessee (sale transaction)

Related Questions

Problem 15-16 Lessee-guaranteed residual value; third-party guaranteed residual value; unguaranteed residual value; executory costs; different interest rates for lessor and lessee [LO15-3, 15-5, 15-8, 15-9]

On December 31, 2013, Yard Art Landscaping leased a delivery truck from Branch Motors. Branch paid $35,000 for the truck. Its retail value is $59,816.

The lease agreement specified annual payments of $17,000 beginning December 31, 2013, the inception of the lease, and at each December 31 through 2016. Branch Motorsâ interest rate for determining payments was 10%. At the end of the four-year lease term (December 31, 2017) the truck was expected to be worth $11,000. The estimated useful life of the truck is five years with no salvage value. Both companies use straight-line depreciation.

Yard Art guaranteed a residual value of $4,000. Guarantor Assurance Corporation was engaged to guarantee a residual value of $7,000, but with a deductible equal to any amount paid by the lessee ($7,000 reduced by any amount paid by the lessee). Yard Artâs incremental borrowing rate is 9%.

A $2,000 per year maintenance agreement was arranged for the truck with an outside service firm. As an expediency, Branch Motors agreed to pay this fee. It is, however, reflected in the $17,000 lease payments.

Collectibility of the lease payments by Yard Art is reasonably predictable and there are no costs to the lessor that are yet to be incurred. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

Required:

How should this lease be classified by Yard Art Landscaping (the lessee)?

	Operating lease
	Capital lease: Sales-type lease
	Capital lease
	Capital lease: Direct financing lease

2.	Calculate the amount Yard Art Landscaping would record as a leased asset and a lease liability.(Round your intermediate calculations to the nearest dollar amount.)

3.	How should this lease be classified by Branch Motors (the lessor)?

	Operating lease
	Capital lease
	Capital lease: Sales-type lease
	Capital lease: Direct financing lease

4.	Show how Branch Motors calculated the $17,000 annual lease payments.

5.	Calculate the amount Branch Motors would record as sales revenue. (Round your intermediate calculations to the nearest dollar amount.)

6.	Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2013. (If no entry is required for a particular transaction, select "No journal entry required" in the first account field. Enter your answers in whole dollars.)

7.	Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Yard Art.

8.	Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Branch Motors.

9.	Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2014. (If no entry is required for a particular transaction, select "No journal entry required" in the first account field. Round your intermediate calculations to the nearest dollar amount. Enter your answers in whole dollars.)

10.	Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2016 (the final lease payment). (If no entry is required for a particular transaction, select "No journal entry required" in the first account field. Round your intermediate calculations to the nearest dollar amount. Enter your answers in whole dollars.)

11.

Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2017 (the end of the lease term), assuming the truck is returned to the lessor and the actual residual value of the truck was $2,000 on that date. (If no entry is required for a particular transaction, select "No journal entry required" in the first account field. Round your intermediate calculations to the nearest dollar amount. Enter your answers in whole dollars.)

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Problem 15-15 Sales-type lease; bargain purchase option exercisable before lease term ends; lessor and lessee [LO15-3, 15-5, 15-6, 15-7, 15-8]

Mid-South Auto Leasing leases vehicles to consumers. The attraction to customers is that the company can offer competitive prices due to volume buying and requires an interest rate implicit in the lease that is one percent below alternate methods of financing. On September 30, 2013, the company leased a delivery truck to a local florist, Anything Grows.

The lease agreement specified quarterly payments of $5,500 beginning September 30, 2013, the inception of the lease, and each quarter (December 31, March 31, and June 30) through June 30, 2016 (three-year lease term). The florist had the option to purchase the truck on September 29, 2015, for $11,000 when it was expected to have a residual value of $18,000. The estimated useful life of the truck is four years. Mid-South Auto Leasingâs quarterly interest rate for determining payments was 3% (approximately 12% annually). Mid-South paid $41,000 for the truck. Both companies use straight-line depreciation. Anything Growsâ incremental interest rate is 12%.

Hint: A lease term ends for accounting purposes when an option becomes exercisable if itâs expected to be exercised (i.e., a BPO). (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

Required:
1.	Calculate the amount of dealerâs profit that Mid-South would recognize in this sales-type lease. (Be careful to note that, although payments occur on the last calendar day of each quarter, since the first payment was at the inception of the lease, payments represent an annuity due.)

2.	Prepare the appropriate entries for Anything Grows and Mid-South on September 30, 2013. (If no entry is required for a particular transaction, select "No journal entry required" in the first account field. Enter your answers in whole dollars.)

3.	Prepare an amortization schedule(s) describing the pattern of interest expense for Anything Grows and interest revenue for Mid-South Auto Leasing over the lease term. (Enter your answers in whole dollars.)

4.	Prepare the appropriate entries for Anything Grows and Mid-South Auto Leasing on December 31, 2013.(If no entry is required for a particular transaction, select "No journal entry required" in the first account field. Enter your answers in whole dollars.)

5.	Prepare the appropriate entries for Anything Grows and Mid-South on September 29, 2015, assuming the bargain purchase option was exercised on that date. (If no entry is required for a particular transaction, select "No journal entry required" in the first account field. Enter your answers in whole dollars.)

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Lewis Securities Inc. has decided to acquire a new market dataand quotation system for its Richmond home office. The systemreceives current market prices and other information from severalonline data services and then either displays the information on ascreen or stores it for later retrieval by the firmâs brokers. Thesystem also permits customers to call up current quotes onterminals in the lobby.

The equipment costs $1,000,000 and, if it were purchased, Lewiscould obtain a term loan for the full purchase price at a 10%interest rate. Although the equipment has a 6-year useful life, itis classified as a special-purpose computer and therefore fallsinto the MACRS 3-year class. If the system were purchased, a 4-yearmaintenance contract could be obtained at a cost of $20,000 peryear, payable at the beginning of each year. The equipment would besold after 4 years, and the best estimate of its residual value is$200,000. However, because real-time display system technology ischanging rapidly, the actual residual value is uncertain.

As an alternative to the borrow-and-buy plan, the equipmentmanufacturer informed Lewis that Consolidated Leasing would bewilling to write a 4-year guideline lease on the equipment,including maintenance, for payments of $260,000 at the beginning ofeach year. Lewisâs marginal federal-plus-state tax rate is 40%. Youhave been asked to analyze the lease-versus-purchase decision and,in the process, to answer the following questions:

1. Who are the two parties to a lease transaction?
2. What are the five primary types of leases, and what are theircharacteristics?
3. How are leases classified for tax purposes?
4. What effect does leasing have on a firmâs balance sheet?
5. What effect does leasing have on a firmâs capital structure?
1. What is the present value of owning the equipment?(Hint: Set up a time line that shows the net cash flowsover the period to , and then find the PV of these netcash flows, or the PV cost of owning.)
2. Explain the rationale for the discount rate you used to find thePV.
What is Lewisâs present value of leasing the equipment?(Hint: Again, construct a time line.)
What is the net advantage to leasing (NAL)? Does your analysisindicate that Lewis should buy or lease the equipment? Explain.
Now assume that the equipmentâs residual value could be as lowas $0 or as high as $400,000, but $200,000 is the expected value.Because the residual value is riskier than the other relevant cashflows, this differential risk should be incorporated into theanalysis. Describe how this could be accomplished. (No calculationsare necessary, but explain how you would modify the analysis ifcalculations were required.) What effect would the residual valueâsincreased uncertainty have on Lewisâ lease-versus-purchasedecision?
The lessee compares the present value of owning the equipmentwith the present value of leasing it. Now put yourself in thelessorâs shoes. In a few sentences, how should you analyze thedecision to write or not to write the lease?

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FIN 401 Lecture 3: Leasing

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