Question

Question: Winston Industries and Ewing SA enter into an agreement that requires Ewing to build three diesel-electric engines to Winston's specifications. Upon completion of the engines, Winston has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is non-cancelable, becomes effective on January 1, 2019, and requires annual rental payments of €384,532 each January 1, starting January 1, 2019.

The implicit interest rate used by Ewing is 6% and unknown to Winston. Winston's incremental borrowing rate is 8%. The total cost of building the three engines is €2,600,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Winston depreciates similar equipment on a straight-line basis. At the end of the lease, Winston assumes title to the engines. Collectibility of the lease payments is probable.

Required: Assume that Winston incurs legal fees related to the execution of the lease of €30,000. In addition, assume Winston receives a lease incentive from Ewing of €50,000 to enter the lease. Compute the value of the lease liability and the value of the Right-of-Use asset to the lessee at the commencement of the lease. (Round all amounts to the nearest euro.)

Answer 1

Step 1

Introduction:

Lease:

Lease can be defined as the agreement between the lessor and the lessee under which the lessor transfers the right to use to the lessee of the assets involved in lease. Lease may be financial lease or operating lease. Under financial lease risk and reward related to the asset of lease are also transferred to the lessee.

Step 2

Calculation of lease liability:

PV factor:

PV factor=1/(1+r)n                =1/(1+6%)^10              =1.7908

Lease liability=Lease amount×PV factor =$384,532×1.7908 = $688,620

Calculation of right to use asset:

Right to use asset=Lease liability+Execution fees                                =$688,620+$30,000 =$718,620