Operating Leases Exam

Problem 1

Part I:

First of all, operating leases generally provide for both financing and maintenance, and the financial leases do not provide maintenance service.

Second, the operating leases often contain a cancellation clause, and the financial leases are not cancellable.

Third, operating leases are not fully amortized, which mean the rental payment of a lessee could not cover the full cost of asset, the lessor need lease more than one lessee to get the cost of asset return, or just selling the asset. The financial leases are fully amortized, which is the rental payment of a lessee equal to the full price of leased equipment plus a return on invested capital.

For example, rent a car from car rental company, such as Avis and Hertz, is kind of operating lease. Rent a apartment is an operating lease. Buy a big equipment, such as excavator, people usually need financial lease.

Part II:

The firms should capitalizing the lease, report the leased asset as fixed asset and the present value of the future lease payments as a liability.

Pros: if do not capitalizing the lease, for fixed charges as high as or even higher than the loan, and the obligations assumed under the lease may be equally or more dangerous from the standpoint of potential bankruptcy.

Cons: some people argued that leases were not fully recognized, even by sophisticated investors. If this were the case, then leasing could alter the capital structure decision in a significant manner—a firm could increase its true leverage through a lease arrangement, and this procedure would have a smaller effect on its cost of conventional debt, rd, and on its cost of equity, rs, than if it had borrowed directly and reflected this fact on its balance sheet.

Problem 2

From yahoo finance, the Beta shows below:

Weighted Beta: (1,075,000/3,000,000)x1.34+(675,000/3,000,000)x0.88+(750,000/3,000,000)x1.08+

(500,000/3,000,000)x0.78=1.08

r=3.00%+1.08x(11.00%-3.00%)=11.64%

So the investor should expect rate of return on this bond is 11.64%.

Problem 3

Of course the University of La Verne M.B.A. Is right. When we calculate the firm’s net income, we should include the interest expense. However, when evaluating a capital budgeting decision, we generally do not include interest expenses. Any incremental interest expenses will be related to the firm’s decision regarding how to finance the project, which is a separate decision.