CFA Practice Question
Truman Incorporated has just agreed to lease a piece of machinery from Dewitt Corporation. The terms of the lease specify that Truman pay an initial payment of $5,000, and then $4,000 at the end of every year for 10 years. The useful life of the asset is expected to be 15 years. The fair value of the equipment is $32,500, and Truman's incremental borrowing rate is 10%. What is the present value of the lease payments to Dewitt (to the nearest hundred dollars), and is Truman therefore required to capitalize this lease?
A. Present value = $29,600, not capitalized.
B. Present value = $29,600, must capitalized.
C. Present value = $24,600, must capitalized.
Explanation: The present value of the minimum lease payment is $5,000 + ($4,000 x 6.145) = $29,600. As this is more than 90% of the current fair value of the equipment, this lease has to be capitalized.
User Contributed Comments 5
| User | Comment |
|---|---|
| Vaughan | Where does the 6.145 come from?! |
| jayjunk | 6.145 is the value of an annuity of $1 for 10 years at discount rate 10%. |
| molloycm | You can also use the cashflow function on the calculator to get the NPV of $29,600. $29,600/$32500 = 91% of FV which means the lease can be capitalised. |
| bahamas | hp 12 c: N - 10, i - 10, FV - 0, PMT - chs 4000, PV = 24578.27 + initial payment of 5000 |
| indrayudha | To iterate molloycm's BAII steps: CFo=-5000 (the initial payment), press down C01=-4000 (subsequent payments), press down F01=10 (10 years), press NPV I=10 (10%), press down to NPV CPT |