Question

On January 1, 2018, Corp X issued 3%, 3 ½ year Bonds to the public, and also signed a 3 and 1/2 -year lease with PH Corp. Payments of $10,000 on the lease are made at the end of the year for years 1,2 and 3 and ($5,000 in the last period; year 4.) There are no provisions for a bargain purchase or an extension of the lease term. The asset has a fair value of $35,000 and has a useful economic life of 4 years. Corp. X is rated as a BBB rated company by Moody’s Investors-a rating company. Additional Facts 1-BBB Market Interest rates: Date of issue on 12/31/2019

Date of issue                         on 12/31/2019

Year 1     2%                               1.5%

Year 2    2.5%                            2.0%

Year 3    2.75%                          2.5%

Year 4    3,5%                             3.0%

Year 5     4.0%.                           4.0%

1- What is the implicit rate (IRR)on the lease?

2- What type of lease is this?

3- What are the balance sheet effects of this lease on 1/1/18 and 12/31/18?

4-what is the lease expense in 2018?

5-Present the cash flow effects of this lease for 2018.

Answer 1

1. Calculation of Implicit rate ( IRR)

Year	Amount	Present value Factor @4 %	PV amount	Present value Factor@6%	PV amount
1	10,000	0.96	9,600	0.94	9,400
2	10,000	0.924	9,240	0.889	8,890
3	10,000	0.8879	8,879	0.84	8,400
4	10,000	0.8534	8,534	0.79	7,900
Total			36,253		34,590
Cost			35,000		35,000
NPV			+1,253		-410

Since NPV is positive at 4% (1,253) & Negative at 5%(-410) IRR should lie in between 4% to 6%

Rate change for +1,253

IRR = 4% + 1,253/+1253-(-410)

           4% + 1,253/1663 = 4% +1.51% = 5.51%

IRR = 5.51%

Note: Since all the lease payments are equal amounts for 3 years i.e ,10,000 so it is assumed that for 4th year also it would be 10,000 to match it with economic life of asset

2.

It is a capital lease as it satisfies one of below condition.

To be classified as a capital lease under U.S. GAAP, any one of four conditions must be met:

• A transfer of ownership of the asset at the end of the term
• An option to purchase the asset at a discounted price at the end of the term
• The term of the lease is greater than or equal to 75% of the useful life of the asset
• The present value of the lease payments is greater than or equal to 90% of the asset’s fair market value

3.

Balance sheet effect

under Liabilities

3% Bonds as long term debts( assumed bonds issued for capital ) = 31,107

under Assets

Capital asset with present value of lease payments Present value of cash outflows @ 5.51% = 31,107

4.

lease payment for 2018 is 10,000. since present value of 10,000 with 5.51% is 9,448 is towards liability & balance 522 is the lease expense i.e., interest.

5.

Cash flow statement

Investing activities
1. Payment for fixed assets	9,448
Financing activities
1. 3% Bonds issued	31,107
2. Interest paid	522