Accounting in Action: CM2

Accounting in Action: CM2

Earlier, Conner and Martin asked you to analyze four proposals for acquiring a very expensive, very large piece of equipment (refer to Accounting in Action, Chapter 10). None of the proposals they asked you to review involved leasing the new equipment. In light of concerns expressed about the potentially short period of time before new technology makes a machine obsolete, you are surprised that leasing was not considered. From what you remember, leasing provides some real benefits. Recall that the fair value of the new equipment is approximately $685,000 and is expected to have an economic life of eight years.

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When the possibility of leasing equipment is discussed, both Conner and Martin express much interest. They have had prior business dealings with Tyler Leasing Company, and the results have been satisfactory. You call Buzz Tyler and ask him about leasing the new equipment; the next day, he sends you the following proposal: Accounting in Action

Tyler Leasing Company would acquire the equipment and lease it to CM2. The lease payments would be $145,661 for five years, paid at the beginning of each period. CM2 would guarantee the residual value of $125,000 at the end of the lease period. The fair market value of similar equipment is $685,000.

The implicit interest rate in this offer is 10%, which is also CM2 ‘s borrowing rate. Conner and Martin like the proposal and want to know more about the Accounting in Action

benefits of leasing versus owning. Remember that their focus is to go to the bond or equity market at the end of 2013. They do not want to guarantee the residual

Continuing Case 8  Accounting in Action

value. They are also excited about the possibility of reporting only the rental expense on the income statement. In addition, they understand that they may not have to report a liability on the balance sheet, which makes them even happier. Instructions

(a)

Analyze the Tyler Leasing Company proposal. Show Conner and Martin (and also Lopez and Knepp, since they appear to be slightly skeptical of this idea) the effect of the proposal on the company’s balance sheet. Explain to the four the effect on the relationship between debt and equity at the present time.
Access file 4a on the website (Excel File) for information about the company’s current debt and equity positions. Explain the debt and equity relationships assuming the leasing proposal results in an operating lease versus a capital lease. For illustrative purposes, ignore income taxes. Also help Conner and Martin understand why Tyler wants CM2 to guarantee the residual amount.

(b)

Additional Activities: Extend your accounting knowledge

Assuming the leasing alternative is selected, and given your analysis, Conner and Martin are concerned about the residual value guarantee, given the changing technology in this market. They indicate they will agree to this lease only if they do not have to guarantee the residual value.

They place a conference call with Buzz Tyler. He expresses his company’s concern that they stand to lose a considerable amount if the  Accounting in Action

Continuing Case 9

equipment is run down when it is returned to them. Explain the concept of third- party guarantees and how this might be the solution for all concerned.

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