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21. On 1 January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor with the following terms: Annual lease payment due 31 December $50,000 Lease term 5 years Estimated useful life of the machine 6 years Estimated salvage value of the machine $0 Carrying value (cost) of leased asset $160,000 Implied interest rate on lease 8% The firm is reasonably assured of the collection of the lease payments. Which of the following best describes the classification of the lease on the company’s financial statements for 2008? A. Operating lease. B. Sales type lease. C. Direct financing lease.

Ans: B. Under U.S.GAAP, lessee must treat a lease as a capital (finance) lease if any of the following criteria are met: Title to the leased asset is transferred to the lessee at the end of the lease period. A bargain purchase option permits the lessee to purchase the leased asset for a price that is significantly lower than the fair market value of the asset at some future date. The lease period is 75% or more of the asset’s economic life. The present value of the lease payments is 90% or more of the fair value of the leased asset. Under U.S.GAAP, if any one of the capital (finance) lease criteria for lessees is met, and the collectability of lease payments is reasonably certain, and the lessor has substantially completed performance, the lessor must treat the lease as a capital (finance) lease. From the lessor’s perspective, a capital lease under U.S.GAAP is treated as tither a sales-type lease or a direct financing lease. If the present value of the lease payments exceeds the carrying value of the assets, the lease is treated as a sales-type lease. If the present value of the lease payments is equal to the carrying value, the lease is treated as a direct financing lease. It is a sales type lease: the lease period covers more than 75% of its useful life (5/6=83.3%) and the asset is on its books at less than the present value of the lease payments ($199,635) (PMT = $50,000, N=5, i=8%). The firm must have acquired or manufactured the asset if it is recorded at less than the present value of the lease payments.

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22. At the beginning of the year, a lessee company enters into a new lease agreement that is correctly classified as a finance lease, with the following terms: Annual lease payments due at the end of the year $100,000 Lease term 5 years Appropriate discount rate 12% Depreciation method straight-line basis Estimated salvage value $0 With respect to the effect of the lease on the company’s financial statements in the first year of the lease, which of the following is most accurate? The reduction in the company’s: A. pretax income is $72,096. B. cash flow from financing is $56,742. C. cash flow from operations is $72,096.

Ans: B. The present value of the lease is $360,477.62. (n = 5, I = 12%, PMT = $100,000) 12% of the original PV is $43,257.31 and represents the interest component of the payment in the first year. The difference between the annual payment and the interest is the amortization of the lease obligation included in cash flow from financing. $100,000 – 43,257.31 = $56,742.69. A is incorrect. Depreciation is $360,477.62 / 5 or $72,095.52 so the total reduction in pretax income would be interest plus depreciation or $115,352.83 (=43,257.31+72,095.52). C is incorrect. Cash flow from operations would be reduced by the amount of the interest only (43,257.31) because the depreciation would be added back to determine cash flow from operations.

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23. At the beginning of the year, a company issues a $1,000 face value, semiannual coupon, bond with an 8 percent coupon rate maturing in 10 years. The annual market rate of interest at issuance was 12 percent. The initial liability recorded for this bond is closest to: A. $771. B. $774. C. $1,000.

Ans: A. The liability recorded is based on market rates of interest when the bond is issued and not the coupon rate on the bond. The market value of the bond at issuance was $770.60. (FV=1,000, PMT=40, N=20, I=6.0).

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24. At the beginning of the year, two companies issued debt with the same market rate, maturity date, and total face value. One company issued coupon-bearing bonds at par and the other company issued zero-coupon bonds. All other factors being equal for that year, compared with the company that issued par bonds, the company that issued zero-coupon debt will most likely report: A. higher cash flow from operations but not higher interest expense. B. both higher cash flow from operations and higher interest expense. C. neither higher cash flow from operations nor higher interest expense.

Ans: A. When a company issues a zero-coupon bond, cash flow from operations is overstated over the life of the bond. Interest expense is recorded for income statements purposes, but is added back in the statement of cash flows as a non-cash adjustment to cash flow from operations.

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25. A company is considering issuing either a straight coupon bond or a coupon bond with warrants attached. The proceeds from either issue would be the same. If the firm issues the bond with warrants attached instead of the straight coupon bond, which of the following ratios will most likely be lower for the bond with warrants? A. Return on assets. B. Debt to equity ratio C. Interest coverage ratio.

Ans: B. The portion of the proceeds attributable to the warrants would be classified as equity, thus the portion classified as a liability would be smaller (lower). Therefore the debt-to-equity ratio will be lower, for the bonds with warrants. A is incorrect. Since interest expense would be lower for a bond with warrants attached, Net Income would be higher and ROA would be higher. C is incorrect. EBIT would be the same regardless of financing method; the coupon on the bond with warrants attached would be lower if the two issues provided the same proceeds, so the interest coverage (=EBIT/ Interest expense) would be higher for a bond with warrants attached.

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26. On 1 January 2012 a company enters into a lease agreement to lease a piece of machinery as the lessor with the following terms: Annual lease payment due 31 December $75,000 Lease term 6 years Estimated useful life of the machine 7 years Estimated salvage value of the machine $0 Carrying value (cost) of leased asset $300,000 Implied interest rate on lease 7% The firm is reasonably assured of the collection of the lease payments. The total affect on 2012 pre-tax income for the lessor from this lease is closest to: A. $32,143. B. $75,000. C. $82,519.

Ans: C. This is a sales type lease: the lease period covers more than 75% of its useful life (6/7=85.7%) and the asset is on its books at less than the present value of the lease payments ($357,490) (PMT = $75,000, N=6, i=7%). The firm must have acquired or manufactured the asset if it is recorded at less than the present value of the lease payments. The income in the first year will therefore consist of the gross profit on the sale (357,490-300,000)=57,490 plus interest revenue from financing the lease = 25,024(see below) Year Start balance interest PMT End balance 1 357,490 7%x357,490=25,024 75,000 357,490-(75,000-25,024) =307,514 Total income = 57,490 + 25,024 = 82,514

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27.  A company had the following events related to $5 million of 10-year bonds with a coupon rate of 8% payable semi-annually on 30 June and 31 December: Issued on 1 January 2005, when the market rate of interest was 6%. Bought back in an open market transaction on 1 January 2011, when the market rate of interest rate was 8%. Which of the following statements best describes the effect of the bond repurchase on the financial statements for 2011? If the company uses the indirect method of calculating the cash from operations, there will be a: A. $346,511 gain on the income statement. B. $743,873 gain on the income statement. C. $350,984 decrease in the cash from operations.

Ans: C. The book value of the bonds on 1 January 2011 is equal to the present value of the remaining coupon payments and principal discounted at the market rate at time of issue (3% per period). Coupon = 0.08 x0.5x5,000,000=200,000; there are 4 years remaining or 8 coupon payments Book value = 200,000 PVAnnuity (n=8, i=3%)+5,000,000PV(n=8, i=3%) =1,403,938+3,947,046 =5,350,984 Using a financial calculator: PMT = 200,000; FV=5,000,000; I=3%; N=8; Compute PV = 5,350,984, Because the market interest rate when the bonds are brought back (8%) is equal to the coupon rate, the company can buy back the bonds at par, $5,000,000 Cost of repurchase     $5,000,000 Book value                      5,350,984 Gain on retirement             350,984 On the cash flow statement the gain would be deducted from net income in calculating the cash from operations under the indirect method, and the cash paid to repurchase the bonds would be a cash outflow in the financing section.

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28. At the beginning of the year, a company issued a $1,000 face value bond. Interest on that bond is paid semiannually, the annual coupon rate on the bond is 9%, and the bond matures in ten years. The market rate of the interest at the time the bond was issued was 10% on an annual basis. The amount of the initial liability recorded for this bond was closest to: A. $938. B. $961. C. 1,065.

Ans: A. The liability and interest expense recorded are both based on market rates of interest when the bond was issued, not the coupon rate on the bond. The market value of the bond at issuance was $937.68. (FV=1000, PMT=45, N=20, i=5.0).

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29. Bond Features, Inc. (“BFI”) has bonds outstanding with a $900,00 par value. The BFI bonds pay a 4.5% coupon, mature in three years, and have  net book value of $785,000. The bonds are convertible into 20,000 shares of common stock, with a $1 par value. The current market value of the common shares is $62.50. Under U.S.GAAP, the amount that will be recorded as additional paid-in capital if the bonds are immediately converted is closest to: A. $115,000. B. $765,000. C. $1,250,000.

Ans: B. Under U.S.GAAP, bond proceeds are reclassified from debt to equity when the bond is converted into common stock. The amount recorded in additional paid-in capital is the balance of the bond liability after crediting the outstanding bond discount and the common stock issued at par. No gain or loss is recorded from the conversion. Bond discount = net book value – bond par value                         = $785,000 - $900,000= $115,000 Common stock = # shares on conversion x par value                           =20,000 x $1= $20,000 Additional paid-in capital = bond par value – (bond discount + common stock) = $900,000 – (115,000 +20,000) =$765,000

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30. A company receiving leased equipment would prefer a finance lease to an operating lease when it: A. wishes to show a higher cash flow from operations. B. desires a lower debt-to-equity ratio. C. has a low marginal tax rate.

Ans: A. Under an operating lease, the entire lease payment is reported as operating cash outflow. A finance lease allocates the outflow between both operating ad financing cash outflows, with only the interest portion of the lease payment treated as an operating cash outflow. B is incorrect. A company’s leverage ratios will be higher under a finance lease arrangement. The finance lease method creates a lease obligation liability. An operating lease is preferred if a firm wants to keep debt off of its balance sheet. C is incorrect. Companies with higher marginal tax rates prefer finance leases, as expenses are higher in the early period of the lease. A low marginal tax rate does not result in a finance lease preference.