Task: Capital versus Operating Leases
On January 2, 2008, two identical companies, Daggar Corp. and Bayshore Company, lease similar assets with the following characteristics:
1. The economic life is eight years.
2. The term of the lease is five years.
3. Lease payment of $20,000 per year is due at the beginning of each year beginning January 2, 2008.
4. The fair market value of the lease property is $96,000.
5. Each firm has an incremental borrowing rate of 8 percent and a tax rate of 40 percent.
Daggar capitalizes the lease whereas Bayshore records the lease as an operating lease. Both firms depreciate assets by the straight-line method, and both treat the lease as an operating lease for federal income tax purposes.
Required:
Question 1: Explain the effects of classifying a lease as an operating lease on a company's earnings. Explain the effects of classifying a lease as a capital lease on a company's earnings.
Question 2: Compute any deferred taxes resulting from the lease for each firm in the first year of the lease.
Question 3: Compute the effect of the lease on the 2008 reported cash flows from operations for both firms. Explain any differences.
Question 4: Compute the effect of the lease on 2008 reported cash flows from investment activities for both firms. Explain any differences.
Question 5: Compute the effect of the lease on 2008 reported cash flows from financing activities for both firms. Explain any differences.