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2. There is a bargain purchase option.

3. The lease term equals 75 percent or more of the life of the property.

4. The present value of future minimum rental payments equals or exceeds 90percent of the fair

market value of the property at the inception of the lease.

With a capital lease, the lessee records the leased asset and related obligation on the books at the

present value of the future minimum rental payments. In determining the present value of future rental

payments, the discount factor to be used is the lower of the lessor's implicit rate or the lessee's

incremental borrowing rate. As each rental payment is made, the liability is debited for the principal

amount of the payment and interest expense is charged for the interest portion. Since, in theory, the

lessee has acquired the property, he or she will depreciate the asset. The recognition of an asset and

long-term liability provides a balance sheet that more appropriately reflects the company's financial

position and hence allows for more meaningful ratio analysis.

EXAMPLE 13.3 Smith Corporation leased property under a 6-year lease requiring equal year-end annual

payments of $20,000. The lessee's incremental borrowing rate is 12 percent.

At the date of lease, the lessee would report an asset and liability at:

$20,000 X 4.411 14" = $82,228

uPVIFA12,6 present value of

=

annuity for 6 years at 12 percent.

An amortization schedule for the first 2 years follows:

Year Payment InterestO Balance

Principal

0 $82,228

1 $20,000 $9,867 $10,133 $72,095

2 $20,000 $8,651 1,349 $60,746

$1

'12 percent times present value of the liability at the beginning of

the year.

The lessee can determine the periodic rental payments to be made under the lease by dividing the

value of the leased property by the present value factor associated with the future rental payments.

EXAMPLE 13.4 Wilder Corporation enters into a lease for a $100,000 machine. It is to make 10 equal annual

payments at year-end. The interest rate on the lease is 14 percent.

The periodic payment equals:

$loo'oOO $19,171.41

-=

5.2161"

'The present value of an

ordinary annuity factor for

n = 10, i = 14% is 5.2161.

351

TERM LOANS AND LEASING

CHAP. 131

EXAMPLE 13.5 Assume the same facts as in Example 13.5, except that now the annual payments

are to be made at the beginning of each year.

The periodic payment equals:

Year Factor

0 1.o

1-9 4.9464

5.9464

$16,816.90

-=Oâ€™ooO

$lO

5.9464

ociated with a lease agreement can also be computed. Divide the value of the

The interest rate

leased property by the annual payment to obtain the factor, which is then used to find the interest rate

with the help of an annuity table.

EXAMPLE 13.6 Harris Corporation leased $300,000 of property and is to make equal annual payments at

year-end of $40,000 for 11years. The interest rate associated with the lease agreement is:

$300,000

-- - 7.5

$40,000

Going to the present value of annuity table in Appendix D and looking across 11 years to a factor closest to

7.5, we find 7.4987 at a 7 percent interest rate. Therefore, the interest rate in the lease agreement is 7 percent.

The capitalized value of a lease can be found by dividing the annual lease payment by an appropriate

present value of annuity factor.

EXAMPLE 13.7 Property is to be leased for 8 years at an annual rental payment of $140,000 payable at the

beginning of each year. The capitalization rate is 12 percent. The capitalized value of the lease is:

Annual lease payment -- $140â€™000 = $25,162.66

1+ 4.5638

Present value factor

Lease-PurchaseDecision

Often a decision must be made as to whether it is better to purchase an asset or lease it. Present

value analysis may be used to determine the cheapest alternative. This topic was treated in Chapter 8,

â€œCapital Budgeting Including Leasing.â€

Review Questions

1. Intermediate-term financing applies to a period greater than

2. The interest rate on an intermediate-term loan is typically than on a short-term

loan.

3. The interest rate may be either or

When the last payment on a loan is higher than the prior periodic installments it is referred to as

4.

a(n) payment.

[CHAP. 13

TERM LOANS AND LEASING

352

5. In a revolving credit arrangement, the notes evidencing the debt are

6. Restrictive provisions in a loan agreement that vary, based on the borrowerâ€™s situation, are referred

to as provisions.

7. A restriction in a loan agreement that puts a limitation on the borrowerâ€™s future loans is referred

to as a(n) provision.

8. A chattel mortgage has a lien against property except for

,the seller of equipment retains title until the purchaser has met the terms

9. In a(n)

of the contract.

lease, there is a third party who acts as the lender.

10. In a(n)

11. When a company sells an asset it owns and then leases it back, this is referred to as a(n)

arrangement.

12. In an operating lease, the entry each year is to debit and credit

lease, the lessee records the leased property on his or her books as

13. In a(n)

of future minimum rental payments.

an asset at the

of

14. One of the criteria for a capital lease is that the lease term equals or exceeds

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