A Company leases equpiment from B Company on January 1, 2009. The 10 year noncan

Question

A Company leases equpiment from B Company on January 1, 2009. The 10 year noncancelable lease agreement requires that rental payments of $10,000 be made at the end of each year starting on December 31, 2009. The equpiment has a guaranteed residual value of $1,000 at the end of its 10 year economic life. The lease contract specifies that the equipment may be purchased for $5 at the end of the lease term (this amount is substaintially lower than the estimated fair market value of the asset on that date). At the inception of the lease, the fair market value of the leased asset is $56,000. The lessee's incremental borrowing rate is 12%, and the lessor's implicit rate is not known.
o Present value factor of $1, 10 periods, 12%: 0.3220
o Present value factor of an ordinary annuity, 10 periods, 12%: 5.6502
o Present value factor of an annuity due, 10 periods, 12%: 6.3283
What should be the value of the leased asset recorded by the lessee on January 1, 2009?
Answer

Explanation / Answer

Since we only have to compute the value of the lease at its inception, January 1, 2009, this problem is fairly simple (for leases, anyway). Knowing which present value (PV) factors to use is the hardest part of doing a problem like this. First of all, you will need to use the PV of $1 figure for the principal amount of the lease. Next, you will need to use the PV of an Ordinary Annuity for the lease payments. We know this because the payments are made at the END of each year. If they were made at the beginning, you would use the PV of an Annuity Due figure. Now to compute the present value of the lease: I'll put the right numbers down and let you do the computations. 1. PV of the principal ($56,000), 10 periods @ 12%: $56,000 x 0.3220 = ? 2. PV of the lease payments ($10,000/payment), 10 periods @ 12%: $10,000 x 5.6502 = ? 3. Add Parts 1 & 2 together The sum of Parts 1 & 2 equals the amount at which the leased asset should be recorded. This computation is very similar to the one used when pricing a bond. Other notes (for future reference): If the problem had given you both the lessee's incremental borrowing rate and the lessor's implicit rate, you are to use the LESSER of the two. An easy way to remember that is: LEASES use the LESSER rate. Additionally, if the lease payments were made more often than once per year, say semiannually, you would need to divide the rate by 2 and double the number of periods when choosing the appropriate PV factors from a table. If the payments were semiannual in this problem, the rate would need to be 6% for 20 periods. Hope that helps. Please rate.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.