Flying Monkey Enterprise and Planes Inc. separately approach you (Magical Financ
ID: 2456012 • Letter: F
Question
Flying Monkey Enterprise and Planes Inc. separately approach you (Magical Financial Consultants) to design a lease. The specifics are as follows. Lessee: Flying Monkey Enterprise. Incremental borrowing rate is 12%. Lessor: Planes Inc. (A plane manufacturer.) Expected rate of return is 10%. Leased asset: An airplane. Fair value of asset: $10 million. Cost for lessor to manufacture the plane is S8m. Economic life: 20 years. Lessor insists that the residual value be guaranteed. A schedule of residual value is in the table attached. In your meeting with Flying Monkey Enterprise, it insisted that the lease be designed as an operating lease because it does not want to ruin its balance sheet with an enormous liability. In your meeting with Planes Inc., it insisted that the lease be designed as a sales type lease. Law of economics requires that: present value of lease payments + present value of residual value = fair value of asset. This is how I came up with the annual rental payments.) How long can the lease be at most before it become impossible for us to have an operating lease for the lessee? How can we structure the lease (e.g. lease term and the treatment of residual value) so that it is an operating lease for lessee and a capital lease for lessor? Where is the magic? Suppose you succeed in making the lease operating for lessee and capital for lessor. On whose balance sheet is the airplane now?Explanation / Answer
In many cases, the "fair value" of a portion of a building is not easily determinable. If this is true, FAS 13 allows you to skip the present value test [FAS 13, para. 28]. Such leases will, as a rule, never convey ownership, so the only test left to determine whether the lease is capital is whether the lease term is 75% or more of the economic life. A building is typically assigned a life of 20 years or more, so this lease's 10-year term is considerably less than 75%, and the lease is considered operating.
In present case the Fair value is $10million and the lease payments are given in the question so if we consider the lease payments than cost is recovered by end of year 8 so by end of year 8 there is no use to operate lease as an operating lease as the cost is recovered fully hence it can b treated as Finance lease after 8yrs.
The lease term should be less than 7yrs as by that time lease payments doesnt exceeds the fair value by 90% and hence can be treated as operating in books of lessee.