Bargain purchase option for Capital lease classification

[liaaba]

another vague question from schweser,
Scooter has leased equipment for a period of 10 years with the following provisions:
*Lease payments $5,000 per year
*Current value of equipment $45,000
*Estimated useful life of equipment 15 years
*Salvage value no salvage value after 15 years
At the end of ten years, Scooter has the option to buy the equipment for $15,000. The discount rate is 10 percent. Scooter should:
A) capitalize this lease because the present value of the lease payments exceeds 90% of its fair market value.
B) treat this lease as an operating lease.
C) capitalize this lease because the lease term is less than 75% of the economic life of the equipment.
D) capitalize this lease because it involves a bargain purchase.
Your answer: D was incorrect. The correct answer was B) treat this lease as an operating lease.
Criterion Qualify as a capital lease?
The title is transferred to the leassee at the end of the lease period: No
A bargain purchase option exists: No
The lease period is at least 75 percent of the asset’s life: No
The present value of the lease payments is at least 90% of the fair value of the asset: No
PV = $30,723 < 90% of $45,000 = $40,500
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My question is, how do we quantify a “bargain purchase option”? In this case, the purchase option is for 15000, which has a PV of 5783 (and the PV of the MLPs is 30723 as given above, giving a total of 36506, and the PV of the asset is 45000), so this does not qualify as a bargain purchase price? Is there any general rule of thumb for determining if a specific price is a bargain? Or is it because the question didn’t specifically say this option was a bargain purchase option, so it’s not one?….

 

[alpenchev]

Liaaba, the way I look at this: current value of the equipment is $45 000, useful life 15 years, using SL depr we will have $3000 annual depr, and at the end of the 10th year the asset book value will be $15 000. The option to buy it at the same price does not look to me as a bargain. Of course this is just my opinion

 

[liaaba]

Alpenchev, I see your reasoning, but you’re assuming the equipment would be depreciated using SL….
I guess this is one of those things like technical indicators, you need convergence of several indicators, and you definitely came up a counter argument there…
anyone else want to pitch in on this?

 

[DarienHacker]

Found this via Google:
“A bargain purchase option is defined as a provision allowing the lessee to purchase the leased property for a price that is substantially lower than the expected fair value of the property at the date the option becomes exercisable.”
Definitely some room for subjectivity, but to the extent that the writer of the question wants you to be able to exclude D, I think alpenchev’s reasoning is dead on. It doesn’t depend on using SL depreciation (which he’s using as a proxy for fair market value); but with the other commonly used depr methods being accelerated, wouldn’t they in fact strengthen the argument that the buyout isn’t a bargain (since the depreciated price would be even lower)?