Finance Assignment Help With Operating Versus Financial Leases

10.6. Example (Operating versus financial leases)

A firm decides to lease a photocopier and the annual minimum lease payments (MLPs) are $20,000 at the end of each year for three years. The lease agreement starts on January 1st 2003. The discount rate used is 8%.

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Operating lease

Balance Sheet: no entries.

Cash Flow: $20,000 cash outflow each year, classified as cash flows from operations.

Income Statement: annual rental expense of $20,000 will be charged on the income statement.

Capital lease

Balance Sheet: at inception the asset and leasehold liability, which is equal to the present value of the MLPs, will be recorded. The asset will be depreciated over the life of the lease and the principal repayments will reduce the size of the liability, see the table below.

Cash Flow: $20,000 total cash outflow each year, the interest payments are cash outflows from operations, and the principal repayments are cash outflows from financing.

Income Statement: annual rental expense of $20,000 will be divided between interest and principal repayments on the liability as shown in the table below.

Calculation of interest and principal repayments for the capital lease:

Year Opening liability Interest (liability x 8%) Principal Closing liability
2003 $51,542* $4,123 $15,877 $35,665
2004 $35,665 $2,853 $17,147 $18,518
2005 $18,518 $1,482 $18,518 0

* Present value of MLPs.

Income Statement:

Operating lease Capital lease
Year Rental Expense Depreciation* Interest Total Expense
2003 $20,000 $17,181 $4,123 $21,304
2004 $20,000 $17,181 $2,853 $20,034
2005> $20,000 $17,181 $1,482 $18,663
Total $60,000 $51,542 $8,458 $60,000

* Calculate depreciation using the straight-line method with the cost as the opening liability and the salvage value set at zero.

Balance sheet for capital lease:

2003 2004 2005
Assets
Leased assets $51,542 $51,542 $51,542
Accumulated depreciation $17,181 $34,362 $51,542
Leased assets, net $34,361 $17,181 0
Liabilities
Current portion of lease obligation $17,147 $18,518 0
Long-term debt: lease obligation $18,518 0 0
Total $35,665 $18,518 0

Cash Flows:

Operating lease Capital lease
Year Operations Operations Financing Total
2003 $20,000 $4,123 $15,877 $20,000
2004 $20,000 $2,853 $17,147 $20,000
2005 $20,000 $1,482 $18,518 $20,000

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