You have just been hired as the new controller of SWT Services

You have just been hired as the new controller of SWT Services Inc., and on the top of the stack of papers on your new desk is a bundle of draft contracts with a note attached. The note says “please help me to understand which of these leases would be best for our situation.” The note is signed by the president of SWT Services Inc. You have reviewed the proposed contracts, and asked a few questions, and in the process have become aware that the company is facing a large cutback in capital spending to deal with the effect of competitive pressure in the industry. A new customer service system that is heavily IT based is critical in meeting the challenge head on. In order to meet this commitment, you need to identify the lease that will have the lowest total cost in the coming year and overall. As well you will need to address the cash demands of each choice. The leases are for telecommunications and computer equipment and software, and the following information is available.

Lease One: The equipment and software has a fair value of $487,694 and an expected life of six years. The lease has a five-year term. Annual rent is paid each January 1, beginning in 2011, in the amount of $104,300. The implicit rate of the lease is not known by SWT. Insurance and operating costs of $23,500 are to be paid directly by SWT to the lessor in addition to the lease payments. At the end of the lease term, the equipment will revert to the lessor, who will be able to sell it for $85,000. If the lessor is unable to sell the equipment for this amount, SWT will be required to make up the difference.

SWT will likely purchase the equipment for $85,000 if any payments are required under this clause of the lease.

Lease Two: The equipment and software have a fair value of $444,412 and an expected life of seven years. The lease has a five-year term beginning January 1, 2011, with a two-year renewal period. Annual lease payments are made beginning December 31, 2011, in the amount of $137,500. This lease has an implicit rate of 8%. Insurance and operating costs of $26,500 are included in the lease payment. At the end of the initial lease term, the equipment can be leased for another two years for $27,500 per year, including insurance and operating costs, and then at the end of that two-year period, the equipment will belong to SWT.

SWT uses private enterprise GAAP and has a December year end. SWT’s incremental borrowing rate is 10%

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Instructions

(a) Prepare a memo to the president explaining which lease will have the lowest cost in the initial year of the lease andoverall cost for the full term of the lease, including any renewal period for Lease Two. Include in your analysis a comparison of the cash flow requirement under each option for the term of the lease including any renewal option.

(b) Which lease do you recommend the company sign, assuming both will meet the company’s requirements and the equipment proposed in both leases is similar? Bring as many arguments to your recommendation as possible to allow the president to be fully advised of the factors leading to your recommendation.

Memorandum Prepared by:  (Your Initials)

TO:  President of SWT

Date:

I have summarized the information regarding the two leases for the customer service telecommunications and computer equipment that you left with me. 

Both leases are considered capital leases under generally acceptable accounting principles, and I have indicated why this is in the following chart, followed by my detailed calculations. Capital lease arrangements are considered to be purchases from an accounting standpoint, and accordingly, the costs that will affect the income statement each year include: interest expense, depreciation expense and any annual operating costs.

The following table shows that Lease Two has less of an impact on income than Lease One in the 2011 year, and on average over the number of years we will be using the leased equipment.  As both leases provide the SWT with similar equipment that meets our requirement, it is my recommendation that we sign Lease Two. From a cash flow standpoint, the lease payments of Lease One are made in advance every year, while Lease Two payments are made at the end of the year which gives us more liquidity. Please keep in mind that with Lease One, the equipment will not belong to us at the end of the lease term of five years, it will revert to the lessor, and we are required to guarantee the value at that time of $85,000. If we are interested in keeping the equipment, we can decide at the end of the lease term if we wish to purchase the equipment for $85,000; if we do not acquire it, we may be required to make up any deficiency in its market value and this introduces considerable uncertainty. With Lease Two, we will acquire the equipment over the seven year term of the lease and cash flows are clearly defined.  Accordingly, I am recommending Lease Two.

	Lease One		Lease Two
Interest rate used in calculations	10% - implicit rate unknown		8% - lower of implicit rate and incremental borrowing rate
Number of years of use by SWT	5 years		7 years
Present value of minimum lease payments	$487,697	(1)	$444,404	(2)
Type of Lease	Capital	(3)	Capital	(4)
Total cash outflow from minimum lease payments	$606,500	(5)	$557,000	(6)
Average per year (÷12)	$121,300		$79,571
Income statement effect first year
Interest expense	$38,339	(7)	$35,552	(8)
Depreciation expense	$80,539	(9)	$63,486	(10)
Operating expenses	$23,500		$26,500
Total expenses	$142,378		$125,538
Total income statement effect over life of lease and renewal
Interest expense	$118,805	(11)	$112,596	(12)
Depreciation expense	$402,694	(13)	$444,404	(14)
Operating expenses	$117,500	(15)	$185,500	(16)
Total expenses	$638,999		$742,500
Average per year (÷12)	$127,800		$106,071

Refer to Appendix A for details of calculations referenced to the above.
Appendix A:

(1)  $104,300    Annual rental payment

  X 4.16986    PV of an annuity due 5 years at 10% (Table A-5)

$ 434,916.40     PV of minimum lease payments

    $85,000      Guaranteed residual value (or purchase price)

   X .62092    PV of 1 in 5 years at 10% (Table A-2)

  $52,778.20   Present value of guaranteed residual value

$487,694.60   Total present value of minimum lease payments

Excel formula =PV(rate,nper,pmt,fv,type)

Using a financial calculator:
PV	$     ?	Yields $487,695.28
I	10%
N	5
PMT	$ (104,300)
FV	$ (85,000)
Type	1

(2)     $111,000    Annual rental payments ($137,500 – $26,500)

  X 3.99271    PV of ordinary annuity 5 years at 8% (Table A-4)

$ 443,190.81     PV of minimum lease payments

     $1,000      Annual rental renewal period ($27,500 –$26,500)

  X 1.78326    PV of ordinary annuity 2 years at 8% (Table A-4)

   1,783.26

   X .68058      PV of 1 in 5 years at 8% (Table A-2)

  $1,213.65    PV of lease renewal payments

   $444,404.46   Total present value of minimum lease payments

Excel formula =PV(rate,nper,pmt,fv,type)

Using a financial calculator:
PV	$     ?	Yields $443,190.81
I	8%
N	5
PMT	$ 111,000*
FV	$ 0
Type	0

*($137,500 – $26,500)

Using a financial calculator:
PV	$     ?	Yields $1,783.26
I	8%
N	2
PMT	$ 1,000*
FV	$ 0
Type	0

* ($27,500 − $26,500)

Using a financial calculator:
PV	$     ?	Yields $1,213.66
I	8%
N	5
PMT	$ 0
FV	$ 1,783.26
Type	0

(3)  The lease term is greater than 75% of the economic life of the leased asset; that is, the lease term is 83% (5/6) of the economic life.

    The present value of the minimum lease payments equal the fair value of the equipment—see calculation

(4)  The present value of the minimum lease payments is equal to the fair value of the equipment. 

(5)  $104,300 x 5 + $85,000 = $606,500

(6)  [($137,500 – $26,500)*5] + [($27,500 – $26,500) x 2)] = $557,000

(7)  ($487,694 – 104,300) x 10% = $38,339

(8)  $444,404 x 8% = $35,552

(9)  ($487,694 – $85,000) ÷ 5 years = $80,539

(10)$444,404 ÷ 7 = $63,486

(11)Cash outflows from lease (item 5) less PV min. lease payments (item 1)

  ($606,500 – $487,695 = $118,805)

(12)Cash outflows from lease (item 6) less PV min. lease payments (item 2)

  ($557,000 – $444,404 = $112,596)

(13)$487,694 – $85,000 = $402,694 or item 9 X 5

(14)Capitalized amount of the lease or Item 10 X 7 = $444,404

(15)$23,500 X 5 = $117,500

(16)$26,500 X 7 = 185,500