Task: Capital versus Operating Leases
On January 2, 2008, two identical companies, Daggar Corp. and Bayshore Company, lease similar assets with the following characteristics:
1. The economic life is eight years.
2. The term of the lease is five years.
3. Lease payment of $20,000 per year is due at the beginning of each year beginning January 2, 2008.
4. The fair market value of the lease property is $96,000.
5. Each firm has an incremental borrowing rate of 8 percent and a tax rate of 40 percent.
Daggar capitalizes the lease whereas Bayshore records the lease as an operating lease. Both firms depreciate assets by the straight-line method, and both treat the lease as an operating lease for federal income tax purposes.
Required to do:
Q1. Explain the effects of classifying a lease as an operating lease on a company's earnings. Explain the effects of classifying a lease as a capital lease on a company's earnings.
Q2. Compute any deferred taxes resulting from the lease for each firm in the first year of the lease.
Q3. Compute the effect of the lease on the 2008 reported cash flows from operations for both firms. Explain any differences.
Q4. Compute the effect of the lease on 2008 reported cash flows from investment activities for both firms. Explain any differences.
Q5. Compute the effect of the lease on 2008 reported cash flows from financing activities for both firms. Explain any differences.