Question

Trillium Ltd, a small and growing innovative start-up technology company traded on the Toronto Stock Exchange, leased machinery on January 1, 2020 for a term of 10 years. The Company considered purchasing the machinery but instead opted to lease. The machinery is widely known to have a general life span of about 20 years.

At the date of signing the lease contract, the leased machinery and associated lease obligation were correctly recorded at $42,000. The first lease payment of $6,000 was made on December 31, 2020 and the interest rate inherent in the lease contract is 7%.

At the start of the year, the Company had a cash and retained earnings balance of $100,000. Assume the above was the only transaction in the year.

The Company has a December 31 year-end.

Required:

1. For the year-ended December 1, 2020, prepare the relevant parts of the following financial statements:

1. Statement of Financial Position
2. Statement of Profit or Loss

2. Explain, with support, two of the most likely reasons why this specific Company opted to lease the machinery rather than purchase it.

3. Explain how the lease will affect Earnings-before-Interest-Taxes-Depreciation (EBITDA).

4. Explain how the debt-to-equity ratio would be affected if the Company choose to borrow funds from a bank to purchase the machinery rather than leasing it. Be specific.

Answer 1

A. Preparation of Relevant Parts of Financial Statements :-

(i). Statement of Financial Position :-

Trillium Ltd.

Statement of Financial position

For year ended December'2020

ASSETS	AMOUNT ($)
Right To Use Machinery	42,000
Retained Earnings (100,000- 6,000)	96,000
Total	1,38,000
LIABILITIES

Lease Liability	42,000
Cash (100,000- 6,000) (lease rental)	96,000
Total	1,38,000

(ii). Statement of Profit & Loss :-

• Lease Rental ,.............Dr 6,000

To Cash ...Cr 6000

• Profit & Loss .....................Dr 6,000

To Lease Rental...Cr 6,000

A loss of $ 6,000 ( for the year ended 31-dec-2020), to be adjusted with retained earnings

(a). Since Price of Machinery is not given therefore we shall assume price of machinery to be $ 100,000

Present value of Machinery = $ 100,000

Present Value of Lease Rental = 1/(1.07)¹⁰ * 6000= 6,000 * 7.02= 42120

Therefore it would be beneficial from the perspective of finance to lease the machinery.

Fast Turn around time is the other reason for leasing.

(a). To see how lease will affect EBITDA:-

EBTDA before Lease :-$ 100,000

EBTDA After Lease :- $ 100,000- 6,000 = $ 96,000