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FM8e- EOC Sol Ch18 - Chapter 18 Lease Financing ANSWERS TO...

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Chapter 18 Lease Financing ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 18-1 An operating lease is one that typically requires the lessor to service the equipment, that has a lease term that is much shorter than the life of the equipment, and that can be cancelled by the lessee. A capital or financial lease has a lease term that is closer to the expected life of the asset, that requires the lessee to provide maintenance service, and that cannot be cancelled without a substantial penalty. A sale and lease back is generally set up like a financial lease, except the leased property was formerly owned by the lessee, who sells it to the lessor and simultaneously leases it back. These terms are not hard and fast, and actual leases can have some of the characteristics of operating leases and some of financial leases. Rules exist that, when applied, force companies to characterize leases one way or the other. Before 1973, when FASB 13 was passed, firms could lease on a long- term, non-cancelable basis, and thus create a long-term liability, yet not show either the leased asset or the liability on its balance sheet. After FASB 13, most financial or capital leases had to be shown on the balance sheet, with the leased asset appearing as an asset and the PV of the future lease payments appearing as a liability. This is called “capitalizing the lease,” and its purpose was to cause balance sheets to better reflect companies actual financial positions. A lease must be capitalized if any one of the following conditions holds: The lease terms effectively transfer ownership of the property from the lessor to the lessee. The lessee can purchase the property for less than its fair market value when the lease expires. The lease period is 75% or more of the expected life of the asset. This limits the life of the lease. The PV of the lease payments is 90% or more of the initial value of the asset. This can also limit the life of the lease, and also the structure of the lease payments. 18-2 A synthetic lease involves the creation of a special purpose entity (SPE) that (1) gets a loan, often for something like 97% of the cost of the asset which is to be leased plus equity from some source equal to 3% of the cost, (2) then uses those funds to purchase an asset required by the SPE’s sponsoring corporation, and (3) then the SPE leases the asset to the corporation for a term of 3 to 5 years. The asset is typically real property, and it generally has a life of 20 years or more. The sponsoring corporation basically guarantees the SPE’s loan, for when the lease expires the sponsor must either (1) arrange for the loan to be renewed at an interest rate that is appropriate, given the company’s risk and interest rates at the time of the renewal, (2) sell the asset and turn the proceeds over to the lender, and make up any shortfall between the price received and the amount of the loan, or (3) Answers and Solutions: 18 - 1
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pay off the loan and take the asset under its direct ownership rather than that of the SPE.
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