capital lease Ratio Adjustments (Joke??)

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dinesh.sundrani

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New Lease Co. (“NewCo”) has entered a 5-year capital lease payable at $200,000 per year. The present value of the lease payments is $820,000. The New Co. incremental cost of borrowing is 7.0% and the interest rate implicit in the lease is 8.0%. The leased asset will be depreciated on a straight-line basis over the lease term.
Assuming the only change to the 20X2 income statement will be the impact of the capital lease, calculate the net profit margin and interest coverage ratio for the lessee in the initial year (20X2).
New Lease Co.
Income Statement
Fiscal 20X2
Sales Revenue $980,000
Cost of Goods Sold 350,000
Sales & General 170,000
EBIT (Operating Income) 460,000
Pretax Income 460,000
Tax @ 30% 138,000
Net Income 322,000
Net Profit Margin Interest Coverage
a. 17.0% 4.1X
b. 28.7% 8.0X
c. 17.0% 5.1X
d. 18.5% 4.5X
- Dinesh S
 
the answer is B.
Depreciation is equal to 820/5 = 164
interest expense = 820*.08=65.6
EBITadj = EBITunadj - depreciation + payment = 460-164+200 = 496
Interest coverage = 496/65.6 = 7.56 (close to answer B).
Net Income = (EBIT-interest)*(1-tax) = (496-65.6)*.7 = 301
Net profit margin = NetIncome/Sales = 301/980 = 31% (close to B)
 
I am going with B too. But according to the following:
OLD EBIT: 460K
Cap lease: PV * rate (7%) = 820K* .07 = 57,400
New EBIT : 460K- 57.4 K = 402.6 K
Net Income : 402.6 * .7 = 281.82
Thus, Net Margin = 281.82/980 = 28.75%
 
I think these questions are even worse than schweser’s qbank….
so maratikus made the assumption the income statement info given has the lease taken into consideration as an operating lease and now we’re changing it to a capital lease
but what if we assume those numbers are prior to the lease and we’re now incorporating the lease into it (as a capital lease)
if you calculate the pv of a 5 yr annuity of 200k (since it didn’t specify the payments are made immediately, I’m assuming its not an annuity due), it’s not 820k (it’s roughly 798k), so that means there’s a salvage value of approximately 31.5k (pv of about 22k).
so dep would be (820-31.5)/5 = 157.7k
so EBIT = 460 - 157.7 = 302.3k
interest expense is same as what maratikus got above
so interest coverage = 302.3/65.6 = 4.61
NI = (302.3 - 65.6)*0.7 = 165.7k
so profit margin = 165.7/980 = 16.9%
Now, the profit margin is just about 17%, the same as a and c, however, the interest coverage ratio is about the midpoint of those 2 answers and pretty darn close to d…but there are no other interest charges, so interest expense should be pretty solid at 65.6
if you calculate the % diff for the 4 sets of answers,
a. 0.6%, 12.2%
b. 8%, 5.8%
c. 0.6%, 9.8%
d. 8.1%, 2.2%
how do you choose which answer?
were there more info given in the question dinesh? such as whether the numbers given used an operating lease or no lease?
 
maparam Wrote:
——————————————————-
> I am going with B too. But according to the
> following:
>
> OLD EBIT: 460K
> Cap lease: PV * rate (7%) = 820K* .07 = 57,400
> New EBIT : 460K- 57.4 K = 402.6 K
>
> Net Income : 402.6 * .7 = 281.82
> Thus, Net Margin = 281.82/980 = 28.75%
—I think you should use 8% which is the implicit rate for the lease, also, where is dep?
or you’re making the assumption that dep was already included in EBIT? hence they were already treating it as capital lease, but then in that case how come the interest charges wasn’t included….
 
— I think you should use 8% which is the implicit rate for the lease, also, where is dep?
This would be wrong. It says clearly use lower of “Rate implicit in Lease” and the “Opportunity Cost of capital”.
So in this case, you must use 7%.
In fact do the following
PMT=200, N=5, PV=-820,
CPT I/y —> 7.00998%
So your rate for the calculation of Interest exp, and anything else is 7% for this problem.
CP
 
yes it’s from Passmaster, I’ll copy paste the answers once I am back home..
- Dinesh S
 
cpk123 Wrote:
——————————————————-
> — I think you should use 8% which is the
> implicit rate for the lease, also, where is dep?
> This would be wrong. It says clearly use lower of
> “Rate implicit in Lease” and the “Opportunity Cost
> of capital”.
>
—-where does it say that? I didn’t find it in the CFAI text…
> So in this case, you must use 7%.
>
> In fact do the following
> PMT=200, N=5, PV=-820,
> CPT I/y —> 7.00998%
>
> So your rate for the calculation of Interest exp,
> and anything else is 7% for this problem.
>
> CP
 
I have read this both in Stalla and in Schweser.
Schweser has this in italics as a Professor’s note right at the start of the chapter - after they lay out the rules of when a lease becomes a capital lease.
In the rules – the last one: says The PV of Lease payments is equal to or greater than 90% of the fair value of the leased asset. The interest rate used to discount the lease payments is the LOWER of lessee’s incremental borrowing rate or the interest rate implicit in the Lease.
Quote:
The implicit interest rate in the lease is the discount rate that the lessor used to determine the lease payments. It is the lease’s IRR because it is the rate that equates the PV of lease payments to the fair value of the leased asset. Using the lower of the two discount rates increases the PV of the lease payments, and increases the likelihood that the lease will satisfy the 90% criterion, and therefore be classified as a CAPITAL Lease.
Now back to the problem:
New EBIT = 460 - 164 = 296
164 = 820/5 == Depreciation expense
Interest expense = 820 * .07 = 57.4
So Pretax Income = 296 - 57.4 = 238.6
Tax @ 30% = 71.58
So NI = 167.02
Net profit margin = 167.02 / 980 = 17.04%
Interest Coverage = EBIT / Int = 296 / 57.4 = 5.16
So choice C.
 
I agree with cpk. answer should be C. I am also goigng with the assumption that this is a new lease and was not included in the I/S before.
Interest rate for the lease is lower of the incremental borrowing costs and int rate implicit in the lease.
 
cpk123 Wrote:
——————————————————-
> I have read this both in Stalla and in Schweser.
>
> Schweser has this in italics as a Professor’s note
> right at the start of the chapter - after they lay
> out the rules of when a lease becomes a capital
> lease.
>
> In the rules – the last one: says The PV of
> Lease payments is equal to or greater than 90% of
> the fair value of the leased asset. The interest
> rate used to discount the lease payments is the
> LOWER of lessee’s incremental borrowing rate or
> the interest rate implicit in the Lease.
>
> Quote:
> The implicit interest rate in the lease is the
> discount rate that the lessor used to determine
> the lease payments. It is the lease’s IRR because
> it is the rate that equates the PV of lease
> payments to the fair value of the leased asset.
> Using the lower of the two discount rates
> increases the PV of the lease payments, and
> increases the likelihood that the lease will
> satisfy the 90% criterion, and therefore be
> classified as a CAPITAL Lease.
>
—this doesn’t instill that much confidence in me, especially when it said they choose the lower rate so that it satisfy the 90% criterion…
I didn’t get any study notes from schweser and stalla (just straight from the CFAI text), but I bought their qbank, and from the questions from qbank, it seems like schweser has some problems with their material, either outdated material from the past or simply incorrect interpretation, like the numerous quant screwups that’s been posted on this forum already (I’m sure Joey can attest to that)
I did a search and looked at a few links (unfortunately I don’t have time to look through too many), none of them have a precise rule for deciding this discount rate, and that’s probably the way it should be, since it’d be an accounting decision made by the firm (although a few of them did suggest using the comp’s cost of debt, or prior yr’s cost of debt etc). The implicit rate is the one where the pv of lease payments equal the fair market value/selling price (for sales type lease) or the cost (for direct financing lease), I mean, I probably would have no problem with it if it just suggested to use the comp’s cost of borrowing because it’s the most applicable to use given the circumstances, but their reasoning is kinda weak, specifically when they say you should choose the lower rate so that it qualifies as a capital lease, but isn’t the whole point of analyzing these leases is to see if they are indeed capital leases? if you choose a rate that’ll qualify it as a capital lease, then doesn’t that defeat the purpose of this analysis? it should be the rate that’s most appropriate to the lease given it’s terms, risks, and any other considerations, not the one that’ll make it a capital lease…..
“Using the lower of the two discount rates increases the PV of the lease payments, and increases the likelihood that the lease will satisfy the 90% criterion, and therefore be classified as a CAPITAL Lease.”
this almost sounds like an accounting fraud to me…
this is probably going a bit off track and unnecessary, but I hope on the actual CFA exam, we won’t be forced to make such a decision…and none of this was mentioned in CFAI text from what I can remember (I mean the choosing of the lower rate)
 
liaaba Wrote:
——————————————————-
> cpk123 Wrote:
> ————————————————–
> —–
> > I have read this both in Stalla and in Schweser.
>
> >
> > Schweser has this in italics as a Professor’s
> note
> > right at the start of the chapter - after they
> lay
> > out the rules of when a lease becomes a capital
> > lease.
> >
> > In the rules – the last one: says The PV of
> > Lease payments is equal to or greater than 90%
> of
> > the fair value of the leased asset. The
> interest
> > rate used to discount the lease payments is the
> > LOWER of lessee’s incremental borrowing rate or
> > the interest rate implicit in the Lease.
> >
> > Quote:
> > The implicit interest rate in the lease is the
> > discount rate that the lessor used to determine
> > the lease payments. It is the lease’s IRR
> because
> > it is the rate that equates the PV of lease
> > payments to the fair value of the leased asset.
> > Using the lower of the two discount rates
> > increases the PV of the lease payments, and
> > increases the likelihood that the lease will
> > satisfy the 90% criterion, and therefore be
> > classified as a CAPITAL Lease.
> >
>
> —this doesn’t instill that much confidence in
> me, especially when it said they choose the lower
> rate so that it satisfy the 90% criterion…
>
> I didn’t get any study notes from schweser and
> stalla (just straight from the CFAI text), but I
> bought their qbank, and from the questions from
> qbank, it seems like schweser has some problems
> with their material, either outdated material from
> the past or simply incorrect interpretation, like
> the numerous quant screwups that’s been posted on
> this forum already (I’m sure Joey can attest to
> that)
>
> I did a search and looked at a few links
> (unfortunately I don’t have time to look through
> too many), none of them have a precise rule for
> deciding this discount rate, and that’s probably
> the way it should be, since it’d be an accounting
> decision made by the firm (although a few of them
> did suggest using the comp’s cost of debt, or
> prior yr’s cost of debt etc). The implicit rate
> is the one where the pv of lease payments equal
> the fair market value/selling price (for sales
> type lease) or the cost (for direct financing
> lease), I mean, I probably would have no problem
> with it if it just suggested to use the comp’s
> cost of borrowing because it’s the most applicable
> to use given the circumstances, but their
> reasoning is kinda weak, specifically when they
> say you should choose the lower rate so that it
> qualifies as a capital lease, but isn’t the whole
> point of analyzing these leases is to see if they
> are indeed capital leases? if you choose a rate
> that’ll qualify it as a capital lease, then
> doesn’t that defeat the purpose of this analysis?
> it should be the rate that’s most appropriate to
> the lease given it’s terms, risks, and any other
> considerations, not the one that’ll make it a
> capital lease…..
>
> “Using the lower of the two discount rates
> increases the PV of the lease payments, and
> increases the likelihood that the lease will
> satisfy the 90% criterion, and therefore be
> classified as a CAPITAL Lease.”
>
> this almost sounds like an accounting fraud to
> me…
>
> this is probably going a bit off track and
> unnecessary, but I hope on the actual CFA exam, we
> won’t be forced to make such a decision…and none
> of this was mentioned in CFAI text from what I can
> remember (I mean the choosing of the lower rate)
REading the responses did jog a vague memory so i checked the CFAI books once i got home.
a.The footnotes (pg 562) say that for purpose of lease classification, the discount rates used to calculate NPV should be the lessee’s incremental borrowing rate or the lessor’s implicit interest rate whichever is lower. (Also problem 8, references the same fact)
b. The section on the financial reporting (571 of cfai notes) say that the discount rate should reflect the risk class of the c/o being analyzed. The interest rate implicit in the lease is a good approximation.
Anyway, what i was trying to say is that given conservatism principle and all that why would one calculate npv @ a higher interest rate then the rate at which the interest is calculated for adjustment?
 
sv102307 Wrote:
——————————————————-
> REading the responses did jog a vague memory so i
> checked the CFAI books once i got home.
> a.The footnotes (pg 562) say that for purpose of
> lease classification, the discount rates used to
> calculate NPV should be the lessee’s incremental
> borrowing rate or the lessor’s implicit interest
> rate whichever is lower. (Also problem 8,
> references the same fact)
—-ahhh, this is one of those footnotes, so I missed it, thanks for the reminder…this is actually GAAP stuff, this is interesting…
> b. The section on the financial reporting (571 of
> cfai notes) say that the discount rate should
> reflect the risk class of the c/o being analyzed.
> The interest rate implicit in the lease is a good
> approximation.
>
>
> Anyway, what i was trying to say is that given
> conservatism principle and all that why would one
> calculate npv @ a higher interest rate then the
> rate at which the interest is calculated for
> adjustment?
—-is this a rhetorical question? anyway, there’s a footnote at the bottom that said the implicit rate could be different from the firm’s cost of borrowing, and depending on market conditions, analyst maybe choose to use the cost of borrowing if it’s more appropriate
 
Choice “c” is correct. The capital lease’s depreciation expense is calculated over five years on a straight-line basis and appears pre-EBIT. The capital lease’s interest expense is calculated on the initial year’s opening lease liability of $820,000 using the lowest financing rate available (7.0%).
New Lease Co.
Income Statement
Fiscal 20X2
Sales Revenue $980,000
Cost of Goods Sold 350,000
Sales & General 170,000
Depreciation Expense* 164,000
EBIT (Operating Income) 296,000
Interest** 57,400
Pretax Income 238,600
Tax @ 30% 71,580
Net Income 167,020
*Depreciation Expense = $820,000 / 5 Years = $164,000
**Year 1 Interest Expense = $820,000 x 7.0% = $57,400
- Dinesh S
 
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