Final answer:
The lessee calculates the present value of minimum lease payments using the incremental borrowing rate or the interest rate implicit in the lease. This valuation is important in accurately reporting lease obligations. Interest rate fluctuations significantly impact investment values, as shown by changes in bond valuations. The correct answer is option: b. incremental borrowing rate.
Step-by-step explanation:
The lessee computes the present value of the minimum lease payments using either the lessee's incremental borrowing rate or, if it can be readily determined, the interest rate implicit in the lease. If the rate cannot be readily determined, the lessee will use their own incremental borrowing rate, which is the rate the lessee would have to pay if they were to borrow the funds necessary to purchase the leased asset on a collateralized basis over a similar term and with similar payments. This concept is crucial in lease accounting, as it accurately measures the cost of the lease obligation in present terms.
By understanding the concepts of interest rate risk and opportunity cost, individuals can see how fluctuations in interest rates affect the present discounted value of future payments. When interest rates rise, the present value of future payments, discounted at the higher rate, will be lower, as understood in the context of bond investments. Hence, a bond bought at an 8% interest rate will be less valuable if the market rate rises to 11% because the same future dollar payments are now discounted at a higher rate, leading to a decrease in the investment's present value.