Question

Problem 4

Rent A Car, Inc. (RAC) purchased 100 vehicles on January 1, 2020, spending $2 million plus 11 percent total sales tax for a total cost of $2,220,000. RAC expects to use the vehicles for five years and then sell them for approximately $360,000. RAC anticipates the following average vehicle use over each year ended December 31:

	2020	2021	2022	2023	2024
Kilometers per year	15,000	20,000	10,000	10,000	5,000

To finance the purchase, RAC borrowed $1.8 million by signing a 6% promissory note.  The note is to be repaid in full by December 31, 2024.  On December 31 of each year, RAC makes one payment on the installment note comprising blended interest and principal components.  The amortization schedule for the note is presented below.  RAC has a December 31 year-end.  The company does not make monthly adjustments, but rather makes adjusting entries every quarter.

The note carries loan covenants that require RAC to maintain a minimum times interest earned ratio of 3.0. RAC forecasts that the company will generate the following sales and preliminary earnings (prior to recording depreciation on the vehicles and interest on the note). For purposes of this question, ignore income tax.

	2020	2021	2022	2023	2024
Sales Revenue	$2,000,000	$2,500,000	$2,800,000	$2,900,000	$3,000,000
Income before depreciation and interest expense	1,000,000	800,000	900,000	1,200,000	1,100,000

Required:

1. Assuming the company makes the required annual payments on December 31, use the amortization schedule to determine:
   1. The amount of the annual payment                                                           
   2. The total interest and principal paid over the note’s life                           

2. What portion of the Note Payable balance would be reported as current versus noncurrent on the December 31, 2021, balance sheet? Fill-in the two blanks below.

Note Payable, Current $                                              

Note Payable, Noncurrent                                          

3. Calculate the depreciation expense that would be recorded in 2020 and 2021, using the (a) straight-line, (b) double-declining balance, and (c) units-of-production depreciation method. [5 marks]

                                                                                                2020                            2021    

a) straight line:

b) double-declining balance:

c) units-of-production:

4. Using the information provided and your answers to requirement 3, determine net income and the loan covenant ratio in 2020 and 2021, assuming the company chooses the (a) straight-line, (b) double-declining-balance, and (c) units-of-production depreciation method. [6 marks]

                                                                                                2020                            2021    

a) straight line:

Net Income =

Times Interest Earned Ratio =

b) double-declining balance:

Net Income =

Times Interest Earned Ratio =

c) units-of-production:

Net Income =

Times Interest Earned Ratio =

5. Using your answers to requirement 4, indicate whether the loan covenant would be violated under the (a) straight-line, (b) double-declining-balance, and (c) units-of-production depreciation method.
6. If the loan covenant is violated at any point in requirement 5, what can the company do to make sure they are not offside?

Answer 1

As per the requirement of the question, the amortization schedule of the notes payable should have been given in the question. However since the same is not given, i have developed the table on my own assuming the payments to be 5 equal installments. In case the amortization schedule is different from the one i have made. Do let me know in the cooment section.

Year	Instalment	Interest	Repayment	Balance
				$   18,00,000
12/31/2020	$   4,27,314	$   1,08,000	$    3,19,314	$   14,80,686
12/31/2021	$   4,27,314	$      88,841	$    3,38,472	$   11,42,214
12/31/2022	$   4,27,314	$      68,533	$    3,58,781	$     7,83,433
12/31/2023	$   4,27,314	$      47,006	$    3,80,308	$     4,03,126
12/31/2024	$   4,27,314	$      24,188	$    4,03,126	$                  -

Required 1

The amount of annual payments = $427,314

Total Interest paid over the note life = $336,568

Total principal paid over the note life = $1,800,000

Required 2

As at 12/31/2021

Note Payable, Current = $358,781   

Note Payable, Noncurrent = $783,433

Required 3

a. Straight line

Depreciation = ($2,220,000 - $360,000) / 5 = $372,000

therefore, Depreciation for 2020 = 372,000 and depreciation for 2021 = 372,000

b. Double Declining balance method

Rate = 2 * 1/5 = 40%

Depreciation for 2020 = $888,000 ($2,220,000 * 40%)

and depreciation for 2021 = $532,800 [($2,220,000 - $888,000) * 40%]

c. Units of production method

Depreciation for 2020 = ($2,220,000 - $360,000) / 60,000 * 15000 = $465,000

Depreciation for 2021 = ($2,220,000 - $360,000) / 60,000 * 20000 = $620,000

Required 4

a. Straight line.

Particulars	2020	2021
Income before depreciation and interest	$      10,00,000	$         8,00,000
Less Depreciation	$         3,72,000	$         3,72,000
Less Interest Expense	$         1,08,000	$            88,841
Net income	$         5,20,000	$         3,39,159
Times interest earned ratio	5.81	4.82

b. Double Declining balance method

Particulars	2020	2021
Income before depreciation and interest	$      10,00,000	$         8,00,000
Less Depreciation	$         8,88,000	$         5,32,800
Less Interest Expense	$         1,08,000	$            88,841
Net income	$               4,000	$         1,78,359
Times interest earned ratio	1.04	3.01

c. Units of production method

Particulars	2020	2021
Income before depreciation and interest	$      10,00,000	$         8,00,000
Less Depreciation	$         4,65,000	$         6,20,000
Less Interest Expense	$         1,08,000	$            88,841
Net income	$         4,27,000	$            91,159
Times interest earned ratio	4.95	2.03

Required 5

  The Loan covenants require RAC to maintain a minimum times interest earned ratio of 3.0.

Thus the loan covenant would be violated in the foloowing situations:

• In the year 2020 when using Double Declining Balance Method
• In the year 2021 when using Units of production Method

Required 6

To comply with the loan covenant, the RAC should use straight line method of depreciation.

For any clarification, please comment. Kindly Up vote.