Question 9.20: Financial Statement Impact of Treating Operating Leases as F......

to 1A: The implicit interest rate on finance leases is 7.245 percent. The implicit interest rate used to discount the finance lease payments is the internal rate of return on the stream of cash flows; that is, the interest rate that will make the present value of the lease payments equal to $12,208. You can use an Excel spreadsheet or a financial calculator for the computations. Set the cash flow at time zero equal to $12,208 (note on Excel and on most financial calculators, you will input this amount as a negative number), input each of the annual payments on the finance leases, and solve for the internal rate of return.

To demonstrate how the internal rate of return corresponds to the individual present values, refer to the following schedule of the undiscounted minimum lease payments based on information from footnote 8 and the assumptions given. Exhibit 12 presents the present value computations.

The interest rate of 7.245 percent approximately equates the future minimum lease payments with the present value of future minimum lease payments of $12,208 that CEC reports.

to 1B: The implicit interest rate is important because it will be used to estimate the present value of the lease obligations reported as a liability, the value of the leased assets on the balance sheet, the interest expense, and the lease amortization on the income statement. For instance, by selecting a higher rate a company could, if desired, opportunistically reduce the present value of its finance leases and thus its reported debt. The reasonableness of the implicit interest rate can be gauged by comparing it to the interest rates of the company’s other debt instruments outstanding, which are disclosed in financial statement footnotes, and by considering recent market conditions. Note, however, that the interest rate implicit in capitalization of the finance lease obligations reflects the interest rate at the time the lease occurred and thus may differ from current rates.

to 2: If the operating leases had been treated as finance leases, the additional amount that would be reported as a lease obligation on the balance sheet at 28 December 2008, using a discount rate of 7.245 percent determined in Part 1 given earlier, is $520,256. Exhibit 13 presents the present value computations. An alternative short cut approach is to divide the discounted finance lease cash flows of $12,208 by the undiscounted finance lease cash flows of $18,205 and then apply the resulting percentage of 67.06 percent to the undiscounted operating lease cash flows of $803,907. The shortcut approach estimates the present value of the operating lease payments as $539,100, which is close to the estimate obtained using the longer method. It is likely to be most accurate when the timing and relative quantities of the two sets of cash flows are similar.

to 3: The debt-to-equity ratio almost doubles, increasing to 8.78x from 4.74x when capitalizing the operating leases. The adjusted debt-to-equity ratio is computed as follows:

(Table 2)