Case study-AW84 Online Services
Problem 1 (20 Points) – Construct a Facility vs. Leasing Decision
Today is January 1, 2015. You have just discovered a “natural spring” on your property, and have decided to start a Bottled Water Company. As a result, you are in need of acquiring the use of a bottling facility. However, you are uncertain of whether your idea will be a success, and thus are trying to decide whether leasing or buying the bottling facility and equipment makes sense.
The possible options are as follows
Construct a Bottling Facility
You can build a bottling facility, including the bottling equipment, near your natural spring at a cost of $ 1,000,000. While you don’t have $ 1,000,000, a bank is willing to loan you $ 900,000 as long as you make a $ 100,000 down payment on the building.
The terms of the bank loan are that you would be required to make a total of five equal annual payments, with the first payment due on December 31, 2015 and the last annual payment due on December 31, 2019. The amount owed to the bank after the last payment will be $ 0. The bank will charge you an interest rate of 12% on their loan, and the interest component of your payments would be deductible for tax purposes.
For income tax purposes, the bottling facility and equipment would be considered
“10-Year Property”, and will be depreciated according to the schedule found on the last page of this exam. At the end of ten years, the bottling equipment will be worthless and in need of replacement. However, you do expect that the facility itself will have value, and you believe that you could sell the facility for $ 300,000 at the end of ten years.
The bottling facility referenced above has a capacity of 2,000,000 bottles of water per year, which is identical to the capacity available at the facility described below.
Lease a Bottling Facility
A local soda manufacturer just went out of business. As a result, the owner of their bottling facility is looking for a new tenant, and he has offered you the opportunity to “lease” his bottling facility at a rate of $ 75,000 per year. He is willing to offer you a five year lease at that rate, with an “option” to renew for another five years at a rate of
$ 110,000 per year. Any lease payments would be due at the beginning of the respective year. Unfortunately, the owner of the facility has told you that at the end of ten years, a new highway will be built through the site of this bottling facility. Therefore, at the end of ten years, you will have to find another location to bottle your water.
One drawback of leasing the existing bottling facility is that you would have to hire a trucking company to “transport” your spring water to the bottling facility. A local trucking firm has offered to do this for you at a price of 5 cents per “bottle”. They will agree to transport any volume of water at this price, with a minimum of 100,000 bottles per year. The trucking firm is willing to sign this agreement for five years, and will give you the option to “renew” under the same terms for another five years at the end of the fifth year.
All lease payments should be considered “tax deductible” at the end of the year in which the payment is made. For example, a lease payment made on January 1, 2015 would be deductible for the year ending December 31, 2015. The “transportation expenses” for trucking your water would also be deductible at the end of the year in which they were incurred.
Assume that your company will be very profitable, and that you pay taxes at a rate of 40% per year. Assume that this rate applies to all “types” of income – ordinary income, capital gains, etc., and that you receive a tax “refund” calculated using this rate if you have a “capital loss”. Unless indicated otherwise, assume that you plan on producing 400,000 bottles of water each year.
(A) (7) If you plan on staying in business for ten years, and if your “cost of capital” is 12%, should you construct your own bottling facility, or lease the one described above? You must support your answer to receive credit.
(B) (3) From a financial reporting perspective, would the lease that is referred to above be an “operating lease” or a “capital lease”? Why?
(C) (4) If the Current Exposure Draft (2013) related to Lease accounting becomes GAAP, would the accounting for the lease described in the problem change? If so, in what way(s)? (The current Leasing Project is referenced below)
(D) (3) Assuming that you remain in business for all ten years, is this decision “sensitive” to your expected production capacity each year? In other words, if you planned on producing at some other capacity other than 400,000, would your decision change? (Feel free to assume that you produce the same number of bottles each year for the ten years.)
(E) (3) Suppose that you are “uncertain” of whether you want to remain in business after the fifth year. If you build a facility and decide to “shut down”your operations at the end of five years, you may assume that you can sell the bottling facility for $ 500,000. Alternatively, if you are leasing the facility,You may decide to not “renew” the lease for the additional five years.
Based on this information, is the “renewal option” (i.e. the option to renew or terminate the lease at the end of five years) valuable? Why or why not? For purposes of this question, “valuable” means relative to a lease in which
you were obliged to pay $ 75,000 for five years and $ 110,000 for years six through ten with no option to terminate the lease at the end of five years.If you make any assumptions, please be certain to indicate what they are.
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Problem 2 (10 Points) – Constructing a Lease
Today is January 1, 2014. You have just picked up the paper and see an opportunity to purchase a building for $ 20,000,000 and lease it back to the current tenant.
So, you decide to call the current tenant, and have learned that the tenant would like to “lease” the building back for ten years, with an option to buy the building back at “fair value” at that point in time. Prior knowledge tells you that similar buildings have an economic life of thirty years. Further, the current tenant would like to report the lease as an operating lease, and would like to make annual lease payments, with the first payment being due on December 31, 2014. Given their current state, the current tenant of the building has an incremental cost of borrowing of 12%.
If you purchase the building, you will be entitled to depreciate it. For sake of simplicity, assume that for tax purposes the building is depreciated using the straight line method over a 32-year period with a salvage value of zero.
The current tenant has agreed to pay all maintenance, property taxes, and any other costs of ownership.
You believe that a building of the type being discussed will appreciate at a rate of 2% per year. If you sell the building at any point in time, you will pay “capital gains” income tax at a rate of 20% of the difference between the selling price and your remaining “cost basis” (i.e. the un-depreciated portion of the initial cost). All other income and benefits is taxed at a rate of 40%.
Given the information above, please complete the following
(A) (5) Assuming that you purchase the building with cash, construct a lease that generates a pre-tax internal rate of return of 10% per year, satisfies the objectives of the client, and has the minimum annual lease payment.
(B) (2) Given the lease that you’ve constructed in Part A, determine the after-tax cash flows for each year. What is the internal rate of return for the after-tax cash flows?
(C) (3) Given your answer to Part B, by how much does your after-tax “Internal Rate of Return” increase if you borrow 80% (i.e. $ 16,000,000) of the cost of the building, with a ten-year, 8% loan with equal annual payments due on December 31 of each year?
Problem 3 (10 Points)
When selling an automobile, TESLA makes the following “Resale Value Guarantee”
A. (4) From an accounting perspective, under what conditions, if any, would a “sale” with an agreement to repurchase the product at a later date at an agreed upon price be considered as a “lease”, rather than as a “sale”? (Keep in mind that Tesla Motors would potentially be a “lessor” for this transaction.)
B. (3) Does the expected value of the vehicle at the time of repurchase, in comparison to the “guaranteed resale value”, matter with regard to the accounting?
C. (3) Does Tesla Motors record such transactions as “sales” or as “leases”? If they record the transaction as a “lease” is it a “sales-type” lease, “direct financing” lease”, or “operating lease”?
Note: Your total answer to the above questions should not exceed one page. Recall that if you would like to do any research of the accounting literature, a Username and Password for the Accounting Standards Codification are included on the syllabus.
Problem 4 (10 Points) – Lessors Accounting for (Leveraged?) Leases
Today is January 1, 2014. Help Me Health Care Company, a non-profit organization, is looking for a lessor to help them finance the acquisition of a Magnetic Resonance Imaging (MRI) machine. The machine sells for $ 2,000,000, and Help Me Health Care does not have the cash or the ability to borrow the money to finance the acquisition.
This is where you come in. You have $ 400,000 of cash, and you also have the ability to borrow $ 1,600,000 from a local bank. The bank would charge you 10% on the loan, with equal annual payments due on December 31 of each year through and including Dec. 31, 2023.
Help Me Health Care has agreed to lease the MRI machine, and is willing to pay
$ 210,000 at the end of each year for the next fifteen years.
For tax purposes, the MRI machine would be considered a property with a seven-year life. The machine is expected to have a salvage value of $ 600,000 at the end of the lease. Your tax rate is 40%, and there are no special provisions (e.g. Investment Tax Credits) available within the tax code.
Assume that you decide to serve as the lessor for Help Me Health Care. Using the information provided above, please prepare a table which indicates how much income you would report each year over the life of the lease in accordance with current U.S. GAAP.
IRS – ALLOWABLE DEPRECIATION AS A % OF COST
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