exercise 3-2 a.

The economic effects of a long-term capital lease on the lessee are similar to that of an equipment purchase using installment debt. Such a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, and obligates the lessee in a manner similar to that created when funds are borrowed. To enhance comparability between a firm that purchases an asset on a long-term basis and a firm that leases an asset under substantially equivalent terms, the lease should be capitalized. b. A lessee should account for a capital lease at its inception as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding any portion of the payments representing executory costs, together with any profit thereon. However, if the present value exceeds the fair value of the leased property at the inception of the lease, the amount recorded for the asset and obligation should be the fair value. c. A lessee should allocate each minimum lease payment between a reduction of the obligation and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the obligation. d. Von should classify the first lease as a capital lease because the lease term is more than 75 percent of the estimated economic life of the machine. Von should classify the second lease as a capital lease because the lease contains a bargain purchase option.

Exercise 3-3 (15 minutes) a. A lessee would account for a capital lease as an asset and an obligation at the inception of the lease. Rental payments during the year would be allocated between a reduction in the obligation and interest expense. The asset would be amortized in a manner consistent with the lessee's normal depreciation policy for owned assets, except that in some circumstances the period of amortization would be the lease term. b. No asset or obligation would be recorded at the inception of the lease. Normally, rental on an operating lease would be charged to expense over the lease term as it becomes payable. If rental payments are not made on a straight-line basis, rental expense nevertheless would be recognized on a straight-line basis unless another systematic or rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis would be used. Problem 3-2 (40 minutes) a. 1/1/Year 1 Enter into Lease Contract: Leased Property under Capital Leases .......................

39,930

Lease Obligation under Capital Leases .................. 39,930 12/31/Year 1 Payment of Rental: Interest on Leases ........................................................ Lease Obligations under Capital Leases .................... Cash ......................................................................... 10,000 Amortization of Property Rights: Amor. of Leased Property under Capital Leases ....... Leased Property under Capital Leases ................. 7,986
(1) $39,930 x .08 = $3,194.40 (2) $39,930 5 = $7,986

3,194.40 (1) 6,805.60

7,986 (2)

b. Balance Sheet December 31, Year 1 LIABILITIES Lease Obligations under $31,944 (1) capital leases.

ASSETS Leased property under capital leases $33,124.40 (2)

Income Statement For Year Ended December 31, Year 1 Amortization of leased property ................................................. Interest on leases.......................................................................... Total lease-related cost for Year 1 .............................................. (3)

$ 7,986.00 3,194.40 $11,180.40

(1) $39,930 - $7,986 = $31,944 (2) $39,930 - $6,805.60 = $33,124.40 (3) To be contrasted to rental costs of $10,000 when no capitalization takes place.

c. Payments of Interest and Principal Total Interest Payment of Payment at 8% Principal 10,000 10,000 10,000 10,000 10,000 $50,000 $3,194.40 2,649.95 2,061.95 1,426.90 736.80 $10,070.00 $6,805.60 7,350.05 7,938.05 8,573.10 9,263.20 $39,930.00 Principal Balance $39,930.00 33,124.40 25,774.35 17,836.30 9,263.20

Year 1 2 3 4 5

d. Expenses to Be Charged to Income Statement Lease Total Expense Amortization Interest Expenses $10,000 $ 7,986.00 $ 3,194.40 $11,180.40 10,000 7,986.00 2,649.95 10,635.95 10,000 7,986.00 2,061.95 10,047.95 10,000 7,986.00 1,426.90 9,412.90 10,000 7,986.00 736.80 8,722.80 $50,000 $39,930.00 $10,070.00 $50,000.00

Year 1 2 3 4 5

e. The income and cash flow implications from this capital lease are apparent in the solutions to parts c and d. The student should note that reported expenses exceed the cash flows in earlier years, while the reverse occurs in later years.

Problem 3-10 (45 minutes) a. Ratio calculations for Jerrys Department Stores (JDS) and Miller Stores (MLS) 1. Price-to-book ratio:
Ratio Book value shares JDS = $6,000 / 250 shares = $24.00 Price/book value = $51.50 / $24.00 = 2.15 MLS = $7,500 / 400 = $18.75 = $49.50 / $18.75 = 2.60

2. Total debt to equity ratio:

Ratio Total debt to equity [Total debt = (S-T debt + L-T debt)] / Equity JDS = $0 + 2,700 / $6,000 = $2,700 / $6,000 = 45.00% MLS =$1,000 + $2,500 / $7,500 = $3,500 / $7,500 = 46.67%

3. Fixed-asset utilization (turnover):

Ratio Sales / fixed assets JDS = $21,250 / $5,700 = 3.73 MLS = $18,500 / $5,500 = 3.36

b. Investment Choice and Justification Based on Part A Based on Westfields investment criteria for investing in the company with the lowest price-to-book ratio (P/B) and considering solvency and asset utilization ratios, JDS is the better purchase candidate. The analysis justification follows:
i. ii. similar iii. Asset turnover turnover 3.73 3.36 JDS: higher Ratio Price-to-book ratio (P/B) Total debt to equity JDS 2.15 45% MLS 2.64 47% Company Favored JDS: lower P/B JDS: lower debt or ratios are very

c.

Investment Choice and Justification Based on Note Information

Note: Details underlying the Balance Sheet Adjustments ($ millions): JDS: i. Leases recognition of MDSs present value lease payments will add $1,000 to JDSs property, plant, and equipment (PP&E) and is offset by a $1,000 addition to JDSs long-term debt. ii. Receivables recognition of JDSs sale of receivables with recourse will increase assets (accounts receivable) by $800 and short-term debt used to finance accounts receivable by $800. MLS: iii. Inventory recognition of LIFO inventory reserve will add $700 to assets (inventory) and $700 to owners equity.

iv.

Pension recognition of current excess funding for the pension plan will add $1,600 to asses and $1,600 to owners equity ($3,400 plan assets $1,800 projected benefit obligation).

Adjusted Calculations Made ($ millions):

JDS: Needed adjustments:
Assets (PP&E) +$1,000 (Accounts receivable) +$800 i. Liabilities (Long-term debt [LTD]) +$1,000 (Short-term debt [STD]) +$800

Book value per common share: No net adjustment to JDS owners equity of $6,000; thus, $6,000 / 250 million shares = $24.00 book value per
share

ii.

Adjusted total debt-to-equity ratio:

$2,700 +1,000 + 800 $4,500 Adjusted debt-to-equity ration = $4,500 / $6,000 = 75% Historical LTD LTD STD Adjusted total debt

iii.

Fixed-asset utilization (turnover) =

$5,700 Historical fixed assets +1,000 PP&E (JDS leases) $6,700 JDS adjusted fixed assets Adjusted fixed-asset utilization (sales/adjusted fixed assets): $21,250 / $6,700 = 3.17

MLS:
Needed adjustments: Assets (Inventory) +$700 (Pension) +$1,600 Owners Equity +$700 +$1,600

i.

Book value per common share:

$7,500 historical equity + $700 + $1,600 = $9,800 Adjusted equity; thus, $9,800 / 400 million shares = $24.50 adjusted book value per share

ii. iii.

Adjusted total debt-to-equity ratio:

Adjusted debt (no adjustments) / Adjusted equity = Adjusted debt / equity $3,500 / $9,800 = 36%

Fixed-asset utilization (turnover):

Sales / Fixed assets (no adjustments) $18,500 / $5,500 = 3.36

Summary of Adjustments:
Ratio MLS Adjusted book value Adjusted debt to equity Fixed-asset utilization JDS $24.00 75% 3.17 $24.50 36% 3.36

Final Results of Analysis: Based on Westfields investment criteria of investing in the company with the lowest adjusted Price-to-Book and considering the adjusted solvency

and asset utilization ratios, MLS is the better purchase candidate. The analysis justification follows:
i. Ratio Price to adjusted book JDS a 2.15 75% MLS b 2.02 36% Company favored MLS lower adjusted P/B MLS lower adjusted debt to MLS higher asset utilization

ii. Adjusted debt to equity equity iii.

a b

Fixed-asset utilization

3.17

3.36

$51.50 / $24.00 = 2.15. $49.50 / $24.50 = 2.02.