Flying Monkey Enterprise and Planes Inc. separately approach you (Magical Financ
ID: 2456980 • 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 $8m. 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.
Required: 1. How long can the lease be at most before it become impossible for us to have an operating lease for the lessee?
2. 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?
3. Suppose you succeed in making the lease operating for lessee and capital for lessor. On whose balance sheet is the airplane now?
Length of Lease (in years)
Annual Rental payments (on Jan 1 of each year)
Residual Value at end of lease
Present Value of Residual Value (at 10% interest rate)
1
$1,363,636.36
$9,500,000.00
$8,636,363.64
2
$1,341,991.34
$9,000,000.00
$7,438,016.53
3
$1,321,065.64
$8,500,000.00
$6,386,175.81
4
$1,300,856.01
$8,000,000.00
$5,464,107.64
5
$1,281,357.91
$7,500,000.00
$4,656,909.92
6
$1,262,565.58
$7,000,000.00
$3,951,317.51
7
$1,244,472.04
$6,500,000.00
$3,335,527.77
8
$1,227,069.15
$6,000,000.00
$2,799,044.28
9
$1,210,347.66
$5,500,000.00
$2,332,536.90
10
$1,194,297.25
$5,000,000.00
$1,927,716.45
11
$1,178,906.62
$4,500,000.00
$1,577,222.55
12
$1,164,163.54
$4,000,000.00
$1,274,523.27
13
$1,150,054.91
$3,500,000.00
$1,013,825.33
14
$1,136,566.88
$3,000,000.00
$789,993.76
15
$1,123,684.84
$2,500,000.00
$598,480.12
16
$1,111,393.61
$2,000,000.00
$435,258.27
17
$1,099,677.40
$1,500,000.00
$296,767.00
18
$1,088,520.00
$1,000,000.00
$179,858.79
19
$1,077,904.77
$500,000.00
$81,754.00
20
$1,067,814.77
$0.00
$0.00
Length of Lease (in years)
Annual Rental payments (on Jan 1 of each year)
Residual Value at end of lease
Present Value of Residual Value (at 10% interest rate)
1
$1,363,636.36
$9,500,000.00
$8,636,363.64
2
$1,341,991.34
$9,000,000.00
$7,438,016.53
3
$1,321,065.64
$8,500,000.00
$6,386,175.81
4
$1,300,856.01
$8,000,000.00
$5,464,107.64
5
$1,281,357.91
$7,500,000.00
$4,656,909.92
6
$1,262,565.58
$7,000,000.00
$3,951,317.51
7
$1,244,472.04
$6,500,000.00
$3,335,527.77
8
$1,227,069.15
$6,000,000.00
$2,799,044.28
9
$1,210,347.66
$5,500,000.00
$2,332,536.90
10
$1,194,297.25
$5,000,000.00
$1,927,716.45
11
$1,178,906.62
$4,500,000.00
$1,577,222.55
12
$1,164,163.54
$4,000,000.00
$1,274,523.27
13
$1,150,054.91
$3,500,000.00
$1,013,825.33
14
$1,136,566.88
$3,000,000.00
$789,993.76
15
$1,123,684.84
$2,500,000.00
$598,480.12
16
$1,111,393.61
$2,000,000.00
$435,258.27
17
$1,099,677.40
$1,500,000.00
$296,767.00
18
$1,088,520.00
$1,000,000.00
$179,858.79
19
$1,077,904.77
$500,000.00
$81,754.00
20
$1,067,814.77
$0.00
$0.00
Explanation / Answer
3. IF we succeed in making the lease operating for lessee and capital for lessor , the airplane will be in the balance sheet of the lessor since it is capital lease for him.
He will treat is as an asset and a liability as well.
he will claim depreciation on the asset and will show the lease payments as liabilities and also deducts the interest expense component of the lease payment each yea