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Finance: Lease Agreement and Capital Budgeting

At the beginning of its accounting year Alice plc leases a machine from Louise Leasing plc. The following information relates to the lease agreement:
1. The term of the lease is 5 years, and the lease agreement is non-cancellable, requiring equal rental payments of £9,276 at the beginning of each year;
2. The machine has a fair value at the inception of the lease of £40,000, an estimated economic life of 5 years, and no residual value;
3. Alice plc's incremental borrowing rate is 10% per year;
4. Alice plc depreciates similar equipment that it owns on a straight-line basis;
5. Louise Leasing plc has set the annual rental to earn a rate of return on its investment of 8% per year; this fact is known to Alice plc.

Required:

(a) Should the above lease agreement be accounted for as a finance or an operating lease? Give reasons to justify your answer.

(b) Prepare the journal entries for Alice plc that relate to the above lease agreement during years 1 and 2 for each of the following assumptions:

(i) The lease is classified as a finance lease;

The actuarial method should be used to allocate finance charges to accounting periods during the lease term.

(ii) The lease is classified as an operating lease.

(c) With reference to (b) discuss the extent to which the distinction between a finance lease and an operating lease is important for financial reporting and analysis.

2-a) Describe the factors that should be taken into consideration by firms when forming their capital structure.

2-b) Describe the "Efficient Market Hypothesis" (EMH). Explain how the "Efficient Market Hypothesis" is used to explain the stock market behaviour.

Solution Preview

Please find the guidelines and proper formatting for the Capital Budgeting & Leasing solution attached.

Running Head: EMH

Capital Budgeting & Leasing

Answer a.
Alice plc leases a machine from Louise Leasing plc. The time period of lease agreement is 5 year. The lease rental would £9276 per year at the beginning of the each year over five year. Cost of machine is £40000 with economic life of five year. Depreciation calculates on straight line basis. Borrowing rate is 10% and discounting rate is 8%. There is no residual value and tax rate is ignored. Tax rate is not given but for the calculation it is assumed equal to 40%.
Option 1:- Operating lease
Lease Rental Paid = 9276
Less: Saving in tax (9276*40%) = 3710
Cash flow in cash of operating lease = £5566
PV of lease rental paid = (5566*PVIFA4yrs, 8%) +5566
(The year is taken equal to as lease rental will be paid at the beginning of each year).
PV = (5566*3.312) +5566
= £24001
Option 2:- Finance the lease
Installment (1) Interest (2) Depreciation (3) Saving in tax (Dep.+Interest)*tax (4) Net cash outflow (5) =(1-4) PV of £1@8% (6) PV of cash outflows (5*6)
12000 4000 8000 4800 7200 0.926 6667.2
11200 3200 8000 4480 6720 0.857 5759.0
10400 2400 8000 4160 6240 0.794 4954.6
9600 1600 8000 3840 5760 0.735 4233.6
8800 800 8000 3520 5280 0.681 3595.7
Total PV of cash outflows 25210.1
Notes:
In the finance leases the payment of loan would be made yearly and it is assumed that the amount of loan would be paid equal basis i.e. £8000 (40000/5) per year. The interest would be calculated in each installment as follow -
Interest for first year = 40000*10% = 4000
Interest for second year = (40000-8000)*10% = 3200
Interest for third year = (32000-8000)*10% = 2400
Interest for fourth year = (24000-8000)*10% = 1600
Interest for fifth year = (16000-8000)*10% = 800
Total installment for each year would be principle payment plus interest payment.
Calculation of depreciation
Total year 5
Total value of asset = £4000
Depreciation per year (Straight line basis) = £ 8000 (40000/5)
The lease should be accounted for as operating lease as it would reduce the value of cash outflows for Alice Plc. The total value of cash outflows under operating lease is £24001 that is less by £1209 than finance lease in which total value is £25210.
Answer b (i).
Journal Entries for Financing lease option
Year 1 Debit Credit
(1) Leased machine under finance lease 40000
Long term liability 40000

(2) Interest expenses 4000
Interest payable 4000

(3) Depreciation expenses 8000
Accumulated depreciation 8000

(4) Lease liability 8000
Interest payable 4000
...

Solution Summary

The solution discusses questions regarding a lease agreement, and capital budgeting and also helps prepare journal entries for Alice.

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