By NEAS - 8/1/2018 8:54:13 PM
FA Module 11 Finance lease practice exam questions
(The attached PDF file has better formatting.)
A firm enters into a four year finance lease on 1/1/20X1.
● Lease payments of 176 are due on January 1 of 20X1, 20X2, 20X3, and 20X4.
● The fair value of the equipment = the present value of the lease payments at the firm’s 4% discount rate.
● The useful life of the equipment is four years and the salvage value is zero; use straight line depreciation.
The firm has earnings before tax and operating cash flow (not including expenses related to the lease) of 277 each year. The tax rate is 20%.
On January 1, 20X1, the firm’s common stock is 534 and its long-term debt is 370.
Use the assumptions in the textbook about how the lease payments are divided between interest expense and reduction of the lease liability.
Question 11.1: Fair value of leased asset
What is the fair value of the equipment on January 1, 20X1?
Answer 11.1: 176 × (1 + 1.04–1 + 1.04–2 + 1.04–3) = 664.42
(fair value = present value of future cash flows)
Question 11.2: Interest expense
What is the interest accrued (= interest expense) in 20X1?
Answer 11.2: 4% × (664.42 – 176) = 19.54
(interest expense = (fair value – lease payment) × discount rate)
Question 11.3: Lease liability
What is the lease liability on December 31, 20X1?
Answer 11.3: 664.42 – 176 + 19.54 = 507.96
(lease liability at the end of the year = lease liability at the beginning of the year – lease payment + interest expense)
Question 11.4: Interest expense
What is the interest accrued (= interest expense) in 20X2?
Answer 11.4: 4% × (507.96 – 176) = 13.28
(interest expense = (fair value – lease payment) × discount rate)
Question 11.5: Lease liability
What is the lease liability on December 31, 20X2?
Answer 11.5: 507.96 – 176 + 13.28 = 345.24
(lease liability at the end of the year = lease liability at the beginning of the year – lease payment + interest expense)
Question 11.6: Depreciation expense
What is depreciation expense in 20X1?
Answer 11.6: 664.42 / 4 = 166.105
(depreciation expense = fair value / estimated useful life)
Question 11.7: Pre-tax income
What is pre-tax income in 20X1?
Answer 11.7: 277 – 19.54 – 166.105 = 91.355
(pre-tax income = earnings before tax excluding the lease – interest expense – depreciation expense)
Question 11.8: Net income
What is net income in 20X1?
Answer 11.8: 91.355 × (1 – 20%) = 73.08
(net income = pre-tax income × (1 – tax rate) )
Question 11.9: Pre-tax income
What is pre-tax income in 20X2?
Answer 11.9: 277 – 13.28 – 166.105 = 97.615
(pre-tax income = earnings before tax excluding the lease – interest expense – depreciation expense)
Question 11.10: Net income
What is net income in 20X2?
Answer 11.10: 97.615 × (1 – 20%) = 78.09
(net income = pre-tax income × (1 – tax rate) )
Question 11.11: Operating cash flow
What is the operating cash flow in 20X1 for GAAP?
Answer 11.11: 277 – 20% × 91.355 = 258.73
(operating cash flow = operating cash flow excluding the lease – tax paid; for simplicity, this practice exam question has operating cash flow excluding the lease = pre-tax income excluding the lease)
Question 11.12: Financing cash flow
What is the financing cash flow in 20X1 for GAAP?
Answer 11.12: -176
(financing cash flow = negative of lease payment)
Question 11.13: Operating cash flow
What is the operating cash flow in 20X2 for GAAP?
Answer 11.13: 277 – 20% × 97.615 – 19.54 = 237.94
(operating cash flow = non-lease operating cash flow – taxes paid – interest paid)
Question 11.14: Financing cash flow
What is the financing cash flow in 20X2 for GAAP?
Answer 11.14: (507.96 – 345.24) / 1.04 = 156.46
(Reduction in lease liability is at the end of the year; financing cash flow is part of the lease payment and occurs at the beginning of the year; divide by the discount rate)
Question 11.15: Return on equity
What is the return on equity in 20X1?
Answer 11.15: 73.08 / ( (534 + 534 + 73.08) / 2) = 12.81%
(return on equity = net income / (average shareholders’ equity)
Question 11.16: Return on equity
What is the return on equity in 20X2?
Answer 11.16: 78.09 / ( (534 + 73.08 + 534 + 73.08 + 78.09) / 2) = 12.09%
(return on equity = net income / (average shareholders’ equity)
Question 11.17: Debt-to-equity ratio
What is the debt-to-equity ratio on December 31, 20X1?
Answer 11.17: (370 + 507.96 + 19.54) / (534 + 73.08) = 147.84%
(debt-to-equity ratio = long-term debt + lease liability + accrued interest) / shareholders’ equity
Question 11.18: Debt-to-equity ratio
What is the debt-to-equity ratio on December 31, 20X1?
Answer 11.18: (370 + 345.24 + 13.28) / (534 + 73.08 + 78.09) = 106.33%
(debt-to-equity ratio = long-term debt + lease liability + accrued interest) / shareholders’ equity
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