Malcolm Ltd., leased equipment from Wilson Inc. on January 1, 2007, for a period of 3 years. Lease payments of $100,000 are due to Wilson Inc. each year. Other expenses (e.g., insurance, taxes, maintenance) are also to be paid by Malcolm Ltd. and amount to $2,000 per year. The lessor (Wilson) did not incur any initial direct costs. The lease contains no purchase or renewal options and the equipment reverts back to Wilson Inc. on the expiration of the lease. The remaining useful life of the equipment is four years. The fair value of the equipment at lease inception is $265,000. Malcolm Ltd. has guaranteed $20,000 as the residual value at the end of the lease term. The salvage value of the equipment is expected to be $2,000 after the end of its economic life. The lessee's (Malcolm's) incremental borrowing rate is 11% (Wilson's implicit rate is 10% and is calculable by the lessee (Malcolm) from the lease agreement).
Present Value of the Lease Obligation
Using the rate implicit in the lease (10%), the present value of the guaranteed residual value would be $15,026 ($20,000 × 0.7513), and the present value of the annual payments would be $248,690 ($100,000 × 2.4869).
Using the incremental borrowing rate (11%), the present value of the guaranteed residual value would be $14,624 ($20,000 × 0.7312), and the present value of the annual payments would be $244,370 ($100,000 × 2.4437)