Question

Leases telecommunications equipment from Photon Company. Assume the following data for equipment leased from Photon Company. The lease term is 5 years and requires equal rental payments of $31,000 at the beginning of each year. The equipment has a fair value at the commencement of the lease of $150,000, an estimated useful life of 8 years, and a guaranteed residual value at the end of the lease of $15,500. Photon set the annual rental to earn a rate of return of 6%, and this fact is known to Callaway. The lease does not transfer title or contain a bargain purchase option, and is not a specialized asset.

Required:
How should Callaway classify this lease?

Answer 1

Financial lease

Step-by-step explanation:

The computation is shown below:

The Present value of minimum lease payments is

= Present value of rental payments + Present value of GRV

= $31,000 × Cumulative PV factor at 6% for 5 periods of annuity due + $15,500 × PV Factor at 6% for 5th period

= $31,000 × 4.46511 + $15,500 × 0.79209

= $138,418 + $12,277

= $150,695

Since the lease payments present value would be more than 90% of the fair value so it would be classified as the financial lease