Finance Lease

CFA Level I
#1

Compared to purchasing an asset, which of the following is the least likely incentive to structure a transaction as a finance lease?

A. At end of the lease, asset is returned to the lessor

B. Lease terms can be negotiated to better each party’s needs

C. Lease enhanced the balance sheet by the lease liability.

I can understand why the answer is C in this case (which is the correct answer), but I am confused on how the answer could not be A as well, given the fact that the opposite is true for a finance lease (asset is transferred to the lessee).

#2

Answer A is a poor choice.

What the question writer apparently meant was on the order of, “Which of the following things _ that actually happens _ in a finance lease is the least likely incentive . . . ?”

Not a well-written question.

#3

I have a followup question (may have bad wording as well).

Company A enters into a finance lease at the beginning of 2016. The lease requires 5 annual payments of $10,000 each year beginning the first day of the lease. Assuming lease interest rate is 8.00%, the interest expense in 2016 is equal to:

  1. 2650

  2. 3194

  3. 3450

I computed 3,450, but the answer is 2,650. I am confused because they subtract off the first lease payment and used that remaining principal to compute the interest expense in the first year. Shouldn’t they use the amount before they subtract off the first lease payment to compute the interest expense in the first year?

Let me know if you need more clarification. Thank you!

#4

They’re correct.

You pay interest only on the amount you still owe. When you make the first $10,000 payment on 1/1/16, you reduce the amount you owe by $10,000.

#5

In a discount or premium bond, we only add or subtract off the amoritized amount in each period to computed the balance of the bond on the books at the end of the period. Why (in this case) are we subtract off the entire 10,000 payment?

#6

It is specified in the question. You have to make "…5 annual payments of $10,000 each year beginning the first day of the lease". As S2000 said, you make the first payment of $10,000 on 1/1/16.

#7

I wrote an article on amortization tables that may be of some help here: http://financialexamhelp123.com/amortization-tables/

Take a careful look at the table for the finance lease.

I’d encourage you to make a similar table for the problem at hand. You’ll learn a lot by doing it yourself.

#8

In your article, is the $20,000 considered the amoritizing amount for the loan?

#9

I’m not sure what you mean by the “amortizing amount”.

€20,000 is the payment.

The first payment is 100% principal; no interest has accumulated.

The second payment is €5,569 interest and €14,431 principal.

The third payment is €4,342 interest and €15,658 principal.

And so on.