Question

The following data below was given. What are some issues with this and how do you account for it properly?

On November 1, 2016 (beginning of the fiscal year), API acquired a portion of its equipment through a lease agreement with Lessor Corp. The lease contract has the following terms and conditions:

- API agrees to lease equipment from Lessor Corp, with a fair market value of $900,000

- The term of the lease is for seven years, with annual rental payments of $145,000 due at the beginning of each year. API knows the implicit interest rate on the lease agreement is 5%. API knows that it could borrow at an incremental rate of 6%.

- There is no residual value.

- API will cover the executory costs associated with the lease. The executor costs will be approximately $10,000 per annum and are included as part of the $145,000 rental payment.

- The lease offers a bargain purchase option to purchase the equipment for $50,000 at the end of the seventh year. At the end of year seven, the fair market value of the asset is expected to be $70,000.

- The first payment was made on November 1, 2016, with annual payments thereafter.

You remember from auditing a client in the past that equipment such as this usually has an economic life of nine years. API has classified this lease as an operating lease. You remember from your discussion with Jeff that he was unsure of the benefits of leasing versus buying an asset. This information is important for Jeff for any future capital budgeting decisions.

Answer 1

Leasing vs. Buying Option:-

Buying Option:-

API has to pay $ 900,000 for purchasing equipment.

Leasing Option:-

Since API (Lessee) has classified this lease as an operating lease hence lessess will not take equipment at the end of lease period.

since lessee has to pay rental payments at the beginning of each year hence for 1st rental payment discounting factor is not applicable.

Year Rental Payment Discounted Factor(at 5%) Discounted Value($)

0 145,000 1 145,000

1 145,000 0.9524 138,098   

2 145,000 0.9070 131,515   

3 145,000 0.8638 125,251

4 145,000 0.8227 119,291

5 145,000 0.7835 113,608  

6 145,000 0.7462 108,199

Total NPV of rental payments 880,962

since in the given solution it is clear that if lessee wants to purchase equipment than they have to bear (900,000-880,962) = 19,038 extra cost.

Conclusion:- It is better for lessee to choose leasing option.