Shen Corporation can either lease or buy a small garage next

Shen Corporation can either lease or buy a small garage next to its business that will provide parking for its customers. The company can lease the building for a period of 12 years, which approximates the useful life of the facility and thus qualifies as a capital lease. The terms of the lease are payments $12,000 per year for 12 years. Shen currently is able to borrow money at a long-term interest rate of 9 percent. The company can purchase the building by signing an $80,000 long-term mortgage with monthly payments of $1,000. The mortgage also carries an interest rate of 9 percent.

1) With regard to the lease option,

A) calculate the present value of the lease

B) Prepare the entry in journal form to record the lease agreement

C) Prepare the entry in journal form to record depreciation of the building

D) Prepare the entries in journal form to record the lease payments for the first two years.

2) With regard to the purchase option,

A) Prepare a monthly payment schedule showing the monthly payment, the interest for the month, the reduction in debt, and the unpaid balance for the first three months

B) Prepare entries in journal form to record the purchase and the first two monthly payments

3) Based on your calculations, which option seemes to be best? Aside from cost, name an advantage and disadvantage of each option.

Solution

1. Lease

A) calculation of the present value of the lease

= ($12,000)*PVIFA(9%, 12 years)

=($12,000)*7.1607

=($85,928.7)

B) The entry in journal form to record the lease agreement as it is capital lease.

Lease Equipment Dr.   $85,928.7

Capital Lease Obligation Cr.   $85,928.7

C) The entry in journal form to record depreciation of the building ($85,928.7/12 =$7160.73)

Depreciation Expenses - Lease Equipment Dr. $7160.73

Accumulated Depreciation Cr. $7160.73

D) Prepare the entries in journal form to record the lease payments for the first two years.

First Year Entry

Lease Obligation Dr. $12,000

Bank Cr. $12,000

Second Year Entry

Lease Obligation Dr. $12,000

Bank Cr. $12,000

2.Purchase

A) Prepare a monthly payment schedule showing the monthly payment, the interest for the month, the reduction in debt, and the unpaid balance for the first three months

B) Prepare entries in journal form to record the purchase and the first two monthly payments

1) Equipment Dr $80,000

Mortgage Payable (Long Term) $80,000

2) First Instalment

Interest Expense Dr. $600

Mortgage Payable (Long Term) Dr. $400

Mortgage Instalment Payable Cr. $1000

Mortgage Instalment Payable Dr. $1000

Cash Cr. $1000

Second Instalment

Interest Expense Dr. $597

Mortgage Payable (Long Term) Dr. $403

Mortgage Instalment Payable Cr. $1000

Mortgage Instalment Payable Dr. $1000

Cash Cr. $1000

3) You should go for Lease option as it has higher NPV of $85,928.7

Aside from cost, name an advantage and disadvantage of each option.

As businesses motto is to maximize wealth and profit. As business grows one has to take some comparative decisions to maximize profit and lower interest cost to maximize working capital. Shortage of fund is not new to business. This type of problem has lead many to look at option of leasing asset or buying it outright.

Lease:- A Lease is long term agreement to rent land, building or any other asset. In return the user (Lessee) makes periodic payment(rent) to owner (Lessor).The lease payment covers cost equipment and other asset and provides Lessor profit. This arrangement gives for most - but not all benefit of ownership of asset. Mostly there are three types of leases (1) Financial Lease,(2) Operating Lease and (3) Sale and Leaseback.

Advantage of Leasing:

1) Down payment is less: Deposit amount which is paid as downpayment in buy is comparative less in lease. That can have a positive impact on business money and cash flows.

2) Tax Deduction: Each of lease Payment id deductible expense under tax and will lower you tax liability.

3) No repairs and maintenance cost: Depends upon your agreement no repairs and maintenance cost required to incurred. which saves your money.

4) No Credit rating: No credit rating is required to acquire the lease. it is easy to qualify.

5) Speedily and Quicker: One can get lease faster than building an asset. This saves time and you can quickly move on business decision.

Disadvantage of Leasing:

1) Lease rental increase: Many lease allows rental to increase periodically and in some leases increase cost when it is renewed.

2) Non renewal of Lease and change of business location: If lessor disagree to renew lease then you have to move to other business location. This can cost you higher and get trouble with your customer.

3) NO ownership: In lease you do not get ownership of asset. So you are not able to take benefit like appreciation in value of asset. No capital growth.

4) No control on asset: With many leases you have little control over asset. so you can’t make decision regarding repairs, maintenance, improvements and others. In such case you have to rely on owner to make decision.

5) Less space for growth: Space in lease is square footage and usually can not be expanded because other companies leasing space in the building. So you dont get enough space for growth.

Purchasing Building

Advantage of Purchasing Building:

1) No rental payment/ fixed loan installments: If you buy a building you don’t have to pay rentals. only fixed loan installments you have to pay. So your monthly budget remains steady. Sometimes you are able to get lower rate interest loan. Finally when loan is paid of you can relive your monthly installments.

2) Tax Benefits: As owner of asset you can get tax benefits of depreciation on asset an interest expense of loan. You can claim deduction of repair, maintenance, taxes and many other cost. Also Improvement in asset you can get depreciation advantage.

3) More space to use Permanent location: Purchasing as building gives you more space to use and you can have permanent business location for your customer. Plus any additional space you can lease to other companies. this will generate more income.

4) Value Appreciation: As times changes value of building goes up and This will add to your companies value.

5) Ownership and control: By purchasing an asset you have total control and ownership of it. You can make decision regarding improvement, repairs and maintenance an many other. You can enjoy uninterrupted use of asset.

Disadvantage of Purchasing Building

1) Initial Cost is higher: Buying a building costs much higher than leasing an asset. You have to large down payment and property appraisal. So companies can not use this funds in day to day operation and can’t have sufficient cash on hand for other investments.

2) More Responsibility: As a owner you are responsible for each and every aspect of asset including financial management and repairs and maintenance. This is major time consuming activity and you cannot focus on business decision.

3) Increase in cost: Property taxes and Insurance cost increase every year which affect companies cash flow adversely.

4) Location downgrades: Sometimes some area becomes outdated which negatively impact customer sales and customers. You must choose area in which you feel confident to do well in future.

5) Finding the right place and premises: One of the biggest challenges is finding a building that fits your company and future plans and its located where you want to be. It is very time consuming activity and can not focus on business activity properly.

Month	Monthly Payment$ A	MonthlyInterest(0.75% per month)$ B	Reduction in debt$ C= A-B	Unpaid balance$ D	Interest Calculation
0	-	-	-	80,000.00
1	1,000.00	600.00	400.00	79,600.00	$80000*0.75%
2	1,000.00	597.00	403.00	79,197.00	$79600*0.75%
3	1,000.00	593.98	406.02	78,790.98	$79197*0.75%