Flying Monkey Enterprise and Planes Inc. separately approach you (Magical Financ
ID: 2718954 • 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: 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 ofresidual 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
Answer1
A lease will not considered ooperating lease if any one of the condition is met
(a) the lease life exceeds 75% of the life of the asset
(b) there is a transfer of ownership to the lessee at the end of the lease term
(c) there is an option to purchase the asset at a "bargain price" at the end of the lease term.
(d) the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.
HENCE,
if the lease life exceeds 75% of the life of the asset then it will not remain as an opearting lease, and will convert into fianancing lease. so, upto 15 years it will remain as operating leas but after that it will be a fianncing lease.
Answer 2
we can structure it in following way
The discount rate used will be the lower of the following two rates:
Going forward, the leased asset is depreciated in a manner consistent with the lessee's usual policy for depreciating its operational assets. It can be over the term of the lease (most common) or over the asset's useful life, if ownership transfers or a bargain purchase option is present.
Answer3
At the inception of a capital lease, the company leasing the equipment will record the equipment as an asset, and the company will also recognize a liability on the balance sheet, by an amount equal to the present value of the minimum lease payments.
So, In Balance sheet of Planes inc. airplanes exist.