Question

Kelvin Industries and Elysia Inc. enter into an agreement that requires Elysia Inc. to build three impulse drive engines to Kelvins' specifications. Upon completion of the engines, Kelvin 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, 2014, and requires annual rental payments of $384,532 each January 1st, starting January 1, 2014.

Kelvins’ incremental borrowing rate is 8%. The implicit interest rate used by Elysias and known to Kelvins is 6%. 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. Kelvin depreciates similar equipment on a straight-line basis. At the end of the lease, Kelvin assumes title to the engines. Collectibility of the lease payments is probable.

Required:

1.     Please show the calculation(s)/discussion of the test you use to answer the following questions:

a.     What type of lease is this for the lessee?    

b.     What type of lease is this for the lessor?

Answer 1

year	cash flows	PVAF@6%	Discounted Cash flows
1-10th year	384,532.00	7.3601	2,830,193.97
Present Value of Minimum Lease payments			2,830,193.97
Cost of building the three engines is $2,600,000
Minimum lease payments are $ 2830,190
The Present valure of lease payments that is $ 2830190 equals 109%(which is more than 90%) of the cost of the asset that is $ 2600,000
Also lease covers complete economic life of the asset that is 10years out of 10 years which is 100% which is more than 75%
All risk of ownership and cost is transferred to lessee and the asset is constructed on the basis of lessees specification.
therefore the lease is a FINANCE LEASE for both the lesses and lessor.
Conditions to become a Finance Lease is complied.