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7/28/2019 Solution for Quiz

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exercise 3-2a. 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 leasetransfers substantially all of the benefits and risks incident to theownership of property to the lessee, and obligates the lessee in a manner

similar to that created when funds are borrowed. To enhance comparabilitybetween a firm that purchases an asset on a long-term basis and a firm thatleases an asset under substantially equivalent terms, the lease should becapitalized.

b. A lessee should account for a capital lease at its inception as an asset andan obligation at an amount equal to the present value at the beginning ofthe lease term of minimum lease payments during the lease term, excludingany portion of the payments representing executory costs, together withany profit thereon. However, if the present value exceeds the fair value ofthe 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 reductionof the obligation and interest expense so as to produce a constant periodicrate of interest on the remaining balance of the obligation.

d. Von should classify the first lease as a capital lease because the lease termis more than 75 percent of the estimated economic life of the machine. Vonshould classify the second lease as a capital lease because the leasecontains a bargain purchase option.

Exercise 3-3 (15 minutes)

a. A lessee would account for a capital lease as an asset and an obligation atthe inception of the lease. Rental payments during the year would beallocated between a reduction in the obligation and interest expense. Theasset would be amortized in a manner consistent with the lessee's normaldepreciation policy for owned assets, except that in some circumstancesthe 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 overthe lease term as it becomes payable. If rental payments are not made on astraight-line basis, rental expense nevertheless would be recognized on astraight-line basis unless another systematic or rational basis is morerepresentative of the time pattern in which use benefit is derived from theleased 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


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Lease Obligation under Capital Leases ..................39,930

12/31/Year 1 Payment of Rental:Interest on Leases ........................................................ 3,194.40 (1)

Lease Obligations under Capital Leases .................... 6,805.60Cash .........................................................................10,000

Amortization of Property Rights:Amor. of Leased Property under Capital Leases ....... 7,986 (2)

Leased Property under Capital Leases .................7,986

(1) $39,930 x .08 = $3,194.40(2) $39,930 5 = $7,986

b.

Balance SheetDecember 31, Year 1

ASSETS LIABILITIESLeased property under Lease Obligations under

capital leases $31,944 (1) capital leases.$33,124.40 (2)


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Income StatementFor Year Ended December 31, Year 1

Amortization of leased property ................................................. $ 7,986.00Interest on leases .......................................................................... 3,194.40Total lease-related cost for Year 1 .............................................. $11,180.40

(3)

(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 PrincipalYear Payment at 8% Principal Balance

$39,930.00

1 10,000 $3,194.40 $6,805.60 33,124.402 10,000 2,649.95 7,350.05 25,774.353 10,000 2,061.95 7,938.05 17,836.304 10,000 1,426.90 8,573.10 9,263.205 10,000 736.80 9,263.20

$50,000 $10,070.00 $39,930.00

d.Expenses to Be Charged to Income Statement

Lease Total

Year Expense Amortization Interest Expenses1 $10,000 $ 7,986.00 $ 3,194.40 $11,180.402 10,000 7,986.00 2,649.95 10,635.953 10,000 7,986.00 2,061.95 10,047.954 10,000 7,986.00 1,426.90 9,412.905 10,000 7,986.00 736.80 8,722.80

$50,000 $39,930.00 $10,070.00 $50,000.00

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

in later years.


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Problem 3-10 (45 minutes)

a. Ratio calculations for Jerrys Department Stores (JDS) and Miller Stores(MLS)

1. Price-to-book ratio:

Ratio J DS MLSBook value = $6,000 / 250 shares = $7,500 / 400shares

= $24.00 = $18.75

Price/book value = $51.50 / $24.00 = $49.50 / $18.75= 2.15 = 2.60

2. Total debt to equity ratio:

Ratio JDS MLS

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

= 45.00% = 46.67%

3. Fixed-asset utilization (turnover):Ratio J DS MLS

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

b. Investment Choice and Justification Based on Part A

Based on Westfields investment criteria for investing in the company withthe lowest price-to-book ratio (P/B) and considering solvency and assetutilization ratios,J DS is the better purchase candidate. The analysisjustification follows:

Ratio J DS MLS Company Favored

i. Price-to-book ratio (P/B) 2.15 2.64 JDS: lower P/B

ii. Total debt to equity 45% 47% JDS: lower debt orratios are very

similar

iii. Asset turnover 3.73 3.36 JDS: higher

turnover

c. Investment Choice and Justification Based on Note InformationNote: Details underlying the Balance Sheet Adjustments ($ millions):

JDS:i. Leasesrecognition 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 willincrease assets (accounts receivable) by $800 and short-term debt used tofinance accounts receivable by $800.

MLS:

iii. Inventory recognition of LIFO inventory reserve will add $700 to assets(inventory) and $700 to owners equity.


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iv. Pension recognition of current excess funding for the pension plan willadd $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 Liabilities(PP&E) (Long-term debt [LTD])+$1,000 +$1,000

(Accounts receivable) (Short-term debt [STD])+$800 +$800

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

ii. Adjusted total debt-to-equity ratio:$2,700 Historical LTD+1,000 LTD

+ 800 STD$4,500 Adjusted total debt

Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%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 Owners Equity(Inventory) +$700 +$700

(Pension) +$1,600 +$1,600

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

ii. Adjusted total debt-to-equity ratio:Adjusted debt (no adjustments) / Adjusted equity = Adjusted debt / equity$3,500 / $9,800 = 36%

iii. Fixed-asset utilization (turnover):Sales / Fixed assets (no adjustments)$18,500 / $5,500 = 3.36

Summary of Adjustments:Ratio J DSMLS

Adjusted book value $24.00 $24.50Adjusted debt to equity 75% 36%Fixed-asset utilization 3.17 3.36

Final Results of Analysis:

Based on Westfields investment criteria of investing in the company withthe lowest adjusted Price-to-Book and considering the adjusted solvency


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and asset utilization ratios, MLSis the better purchase candidate. Theanalysis justification follows:

Ratio JDS MLS Company favored

i. Price to adjusted book 2.15a

2.02b

MLS lower adjusted P/B

ii. Adjusted debt to equity 75% 36% MLS lower adjusted debt toequity

iii. Fixed-asset utilization 3.17 3.36 MLS higher asset utilization

a$51.50 / $24.00 = 2.15.

b$49.50 / $24.50 = 2.02.

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