Assume that Southwest Airlines is planning to purchase a jet passenger plane with a price of $45,636,480 from The Boeing Company. Southwest is considering structuring the transaction in one of two ways. In Alternative 1, Southwest would borrow the necessary cash from Federal City Bank and sign a note requiring payments of $6 million at the end of each year for fifteen years. The proceeds from the loan would then be used to purchase the airplane. In Alternative 2, Southwest would lease the airplane from Boeing and make annual lease payments of $6 million for fifteen years, at which time it could purchase the airplane from Boeing for a nominal sum. Southwest depreciates its aircraft over a useful life of fifteen years, using the straight-line method.
REQUIRED:
a. Determine the effective interest rate on the note and the lease arrangement.
b. Provide the journal entries that would be recorded under Alternative 1 to reflect the borrowing and the purchase of the airplane.
c. Provide the journal entry that would be recorded under Alternative 2 when the lease agreement is signed if the lease is treated as a capital lease.
d. Compare the effects on the financial statements caused by (b) and (c).
e. Provide the journal entry that would be recorded under Alternative 2 when the lease agreement is signed if the lease is treated as an operating lease.
f. Which of the three alternative treatments (borrowing, capital lease, operating lease) could be considered off-balance-sheet financing? Explain why Southwest might want to structure the transaction in this way.