CFA Practice Question

CFA Practice Question

Landmark Securities has acquired the use of a new computer to process its clients' financial data. It has signed a 5-year lease. The computer costs $5 million. Landmark will make annual lease payments of $1,150,000 at year-end. If Landmark wanted to buy the computer it would have been able to finance the purchase at 8%. The computer has a life of 6 years.
A. Landmark should classify this transaction as a capital lease.
B. Landmark should classify this transaction as an operating lease.
C. Landmark should classify this transaction as an operating lease for the first 5 years and then as a capital lease if it adds another year to the lease.
Explanation: To qualify as a capital lease, any one of the following conditions must be met: (1) transfer of ownership to lessee at lease-end, (2) bargain purchase option at lease-end, (3) lease term is at least 75% of equipment life, and (4) present value of lease payments is at least 90% of the fair value of the equipment to the lessor.

In this case, the first two conditions are not satisfied. However, the lease term of 5 years is more than 75% of the life of the computer, i.e., 83.33% (5/6 = 0.833).

The lease also meets the last condition.
PV of lease payments: PMT = 1,150,000; N = 5; I/Y = 8; CPT PV = 4,591,617
This represents over 90% of the fair value of the computer; 4,591,617 / 5,000,000 = 0.918, or 91.8%.

Based on both of these conditions, the lease should be classified as a capital lease. Unless you are asked to test for a specific condition, you only have to test for one of the four to be satisfied. In this case, we do not need to test for the last condition to answer the question.

User Contributed Comments 1

User Comment
MrFortei AN broke the definition down perfectly with an example, you guys rock!
You need to log in first to add your comment.