Question

On Jan. 1, 2011, two identical corporations, Gemtech, Inc., and Silicon Dynamics Corp., lease similar assets with the following characteristics:

           

Lease term is for 5 years.

Lease payments of $18,000 per year are payable at the end of each year, with the first payment due on Dec. 31, 2011.

Each firm has an incremental borrowing rate of 10% and a tax rate of 30%.

Gemtech capitalizes the lease for financial reporting purpose, whereas SILICON DYNAMICS uses the operating lease method. Both firms use straight-line depreciation method for all assets including leased assets on their financial statements and for income tax purpose. Assume that both firms treat the leases as capital lease on their tax returns. Assume also that each firm generates $75,000 for income before lease-related expense and income tax in 2011.

1.Determine the amount of capital lease (PV of the minimum lease payments) Gemtech should record at the beginning of 2011.

2.Determine the amount of lease-related interest & depreciation expenses Gemtech should recognize for 2011.

3.Determine both income tax expenses and income tax payable of Gemtech for 2011.

4.Determine both income tax expenses and income tax payable of Silicon DDynamics for 2011.

5.Determine the amount of 2011 deferred income tax (asset or liability) for Silicon Dynamics.

6.State the effect (increase, decrease or no effect) on (i) debt to equity ratio, (ii) interest coverage ratio, (iii) operating cash flows, and (iv) net income of Silicon DDynamics for 2011, if Silicon Dynamics used capital lease instead of operating lease. Briefly explain why this is.

Answer 1

1.

2.

3. and 4.