AFM 391 Case Concepts

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1 AFM 391 Case Concepts a. Why do companies lease assets rather than buy them? % financing at fixed rates. Leases are often signed without requiring any money down from the lessee, which helps to conserve scarce cash an especially desirable feature for new and developing companies. 2. Protection against obsolescence. Leasing equipment reduces the risk of obsolescence to the lessee, and in many cases passes the risk of residual value to the lessor. 3. Flexibility. Lease agreements may contain less restrictive provisions than other debt agreements. Innovative lessors can tailor a lease agreement to the lessee s special needs. For instance, a ski left operator using equipment for only six months of the year can arrange rental payments that fit well with the operation s revenue streams. In addition, because the lessor retains ownership and the leased property is the collateral it is usually easier to arrange financing through a lease. 4. Less costly financing for lessee, tax incentive for lessor. Some companies find leasing cheaper than other forms of financing. For example, start-up companies in depressed industries or companies in low tax brackets may lease as a way of claiming tax benefits that might otherwise be lost. Investment tax credits and capital cost allowance deductions offer no benefit to companies that have little or no taxable income. Through leasing, these tax benefits are used by the leasing companies or financial institutions. They can then pass some of these tax benefits back to the asset s users through lower rental payments. 5. Off-balance sheet financing. Certain leases do not add debt on a balance sheet or affect financial ratios, and may add to borrowing capacity. Offbalance sheet financing is critical to some companies. For example, airlines use lease arrangements extensively, which results in a great deal of off-balance sheet financing. 6. Transaction cost can be higher for buying an asset and financing it with debt or equity than for leasing the asset. b. What is an operating lease? An operating lease is a lease contract that allows the use of an asset, but does not convey rights similar to ownership of the asset. As well, the period of the contract is less than the life of the equipment and the lessor pays all maintenance and serving fees. The lessor has the risk and benefits of the asset. An operating lease is also not usually fully amortized, and is serviceable and maintained by the lessor. There is also usually an option to cancel the lease. What is a capital lease? A capital lease is a lease that transfers the risk and benefits form the lessor to the lessee. The lessee is responsible for the maintenance, and is fully usually fully amortized. There is no option to cancel unless defaulting through bankruptcy.

2 One of the following three criteria must be met in order to be classified as a capital lease: a. If there is reasonable assurance that the lessee will obtain ownership at the end of the lease, possibly through a bargain purchase option. b. The lease term is long enough that the lease d to be will receive substantially all the economic benefits that are expected to be derived from the use of the lease property over its life. This is usually assumed to occur if the lease term is 75% or more of the lease property s economic life. c. When the present value of the payments (excluding executory costs) to the lessor are greater than 90% of the fair value of the asset. What is direct financing lease? Direct financing lease is basically the coupling of a sale and financing transaction. It is a method used by lessors in capital leases when both of the following criteria for the lessor are satisfied: (1) collectability of minimum lease payments is assured and (2) no important uncertainties surround the amount of unreimbursable costs yet to be incurred. In a direct financing lease, the lessor is not a manufacturer or dealer in the item; the lessor purchases the property only for the purpose of leasing it. What is a sales type lease? A sales type lease is an arrangement whereby a firm leases its own equipment, such as IBM leasing its own computers, thereby competing with leasing companies. In order to be a sales type lease, must meet the following criteria: a. Does lease meet any of group I criteria? (same as lessee s) b. Is risk associated with collection normal? c. Remaining non-reimbursable costs by lessor can be estimated? d. Does asset s fair value equal lessor s book value? If no then it is a salestype lease. c. Why do accountants distinguish between different types of leases? Accountants distinguish between the different types of leases because it gives users of financial statements a more reliable and relevant view of the business. This is especially true in regards to the long term liabilities, as capital leases are often noncancelable and last for the duration of the assets economic life. The company does not have a choice, it must make the lease payment each year. This represents a long term liability at the present time. By not disclosing this on the balance sheet it gives users a false impression of what future liabilities the company will have to incur. Process d. i) Landing fees & other rentals Cash ii) assuming no leases ended and no new leases were signed Landing fees & other rentals Cash

3 e. The Owned property and equipment flight equipment refers to the amount of flight equipment they purchased either through debt, financing or internal funding. While the Capital leases Flight Equipment is the amount of flight equipments that they financed through a capital lease. They own a total of 145 working jets and 434 leased jets. f. Depreciation = (6574-(6574*.15))/30 = 186 million Dr Amortization expense Flight Equipment 186 million Cr Accumulated Amortization Expense Flight Equipment 186 million g. Depreciation =(107-(107*.15))/20 = 4.55million dollars assuming that the plane is returned to the lessor at the end of the lease Dr Amortization expense Leased Equipment 4.55 million Cr Accumulated Amortization Expense Leased Equipment 4.55 million h. The figure can be found on the Balance sheet in the Long Term Debt and Capital Leases account as well as the Current Maturities of Long Term Debt and Capital Leases account. As long term debt is grouped into the same account with capital leases, the figure of $323 million is embedded in the account, and is not shown separately on the statement. This amount is the future minimum payments discounted to the present values using the company s implicit rate. Analysis i. i)using cash flows of the following: Cash flow Period We used a financial calculator to compute IRR of 11.05%. ii) Date Lease Interest Investment Investment Payment Expense Recovery Balance 12/31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/

4 12/31/ /31/ /31/ /31/ Using the effective interest method and the average interest rate calculated above, we have computed an interest expense related to leases for the year that will end December 31 st 2004 of $35.69 million. iii) $44 million will be paid for the leases in fiscal iv) Interest Expense Long Term and Capital Leases Cash v) The current maturities of capital leases as of December 31, 2003 is $ This number differs from Note 6 because the schedule assumes that there is only one payment made at the end of the year, while in reality there can be multiple payments made throughout the year. We also assume that the implicit rate is the same for 2003, when in reality it may be fluctuating from year to year. j. i) Using a financial calculator we calculated the present values of minimum lease payments to be $ using the following table of cash flows. Cash flow Period ii) Flight Equipment - Capital Leases Long-Term and Capital Leases iii)

5 Balance Sheet Account Before After Equipment and Property Under Capital Leases: Flight equipment 107 = Total Assets = iv) Recovery in ( *.12) = Balance Sheet Account Before After Long Term Debt and Capital Leases = ( ) Total Current Liabilities = Total Liabilities = v) The incentive to include airport leases as operating leases is that is reduces the amount of liabilities the entity is required to disclose on its balance sheets. By not disclosing these liabilities on the balance their will be able to borrow more money from lenders, as well appear to be more financially liquid to investors. As well, the additional liabilities will not interfere with debt covenants they already are required to maintain from other lending agreements ( i.e their debt to equity ratio will not increase). Leases affect the quality of the balance sheet by decreasing transparency. Leases make it more difficult for users to see the amount of overall debt that the company has taken and is obligated to pay. k. Ratio Before After Current Ratio Return on Assets Return on Equity Debt to Equity Assuming net income would remain the same. All of the ratios become weaker when leases are capitalized. This is due to the additional debt and counter-balancing assets that are recorded by the company. Current liabilities increases as the current maturities of the capital lease are recorded, which works to increase currents while keep current assets the same. This makes the current ratio decrease, and the company appears less liquid. The total assets are

6 increased as the company records the assets from their capital leases on their balance sheet. The net income, however, will increase because instead of the entire lease payment being expensed; only the interest portion is expensed. This makes the return on assets ratio ambiguous; it could either go up or down depending on how much the net income increases relative to how much the total assets increase. The return on equity will increase because equity stays the same, while net income increases. Total liabilities increase as the obligations from the capital leases are recorded in long term and current sections of the balance sheets. This works to increase the debt-to-equity ratio as more debt is recorded while equity remains the same. So in conclusion, it is not true that the decision to capitalize will always yield weaker ratios; it depends on the increases in net income, assets, and liabilities. l. Delta s depreciation policy is more conservative because it s lower residual value and useful life makes the company amortize more each year and amortizes the asset faster. Depreciation = (6574-(6574*.05))/20 = million Dr Amortization expense Flight Equipment million Cr Accumulated Amortization Expense Flight Equipment million Compared to part f the amortization expense is higher by $ million each year. With Continental having a more aggressive depreciation policy than Delta, it expenses less amortization each year, and as a result has a higher net income each year. Continental records net income $ million higher each year than if it were to use Delta s depreciation policy.

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