Watts Motors plans to acquire a building and can either borrow cash from a bank to finance the purchase or lease the building from the current owner. The sales price of the building is $149,388. If the company wishes to finance the purchase with a bank loan, it must sign a ten-year note with a face value of $149,388 and a stated interest rate of 12 percent. If the company leases the building, it must make an annual lease payment of a constant-dollar amount for ten years, at which time the building can be purchased for a nominal fee.
a. Compute the annual lease payment that would make the two alternatives equivalent. Ignore the nominal purchase fee at the end of Year 10.
b. Describe how the timing of the cash flows would differ between the two alternatives.
c. Provide the journal entries that would be recorded when the building is acquired if the company (1) finances the purchase with a bank loan, (2) leases the building and accounts for it as a capital lease, or (3) leases the building and accounts for it as an operating lease.
d. If the company leases the building and accounts for it as a capital lease, compute the balance sheet value of the lease liability after the second lease payment.
e. Compute the present value of the remaining lease payments as of the end of the second year.