Question

Analyzing and Interpreting Footnote on Operating and Capital Leases

Assume Verizon Communications, Inc., provides the following footnote relating to its leasing activities in its 10-K report. The aggregate minimum rental commitments under noncancelable leases for the periods shown at December 31, 2010, are as follows:

Years (dollars in millions)	Capital Leases	Operating Leases
2011	$ 83	$ 1,449
2012	71	1,316
2013	67	1,056
2014	63	806
2015	46	527
Thereafter	161	1,937
Total minimum rental commitments	491	$ 7,091
Less interest and executory costs	(89)
Present value of minimum lease payments	402
Less current installments	(46)
Long-term obligation at December 31, 2010	$ 356

(a) Confirm that the implicit discount rate for Verizon's capital leases is 5.01%.

N	0	1	2	3	4	5	6	7	8	9
Amount	Answer	Answer	Answer	Answer	Answer	Answer	Answer	Answer	Answer	Answer
IRR	Answer

(b) What effect does the failure to capitalize operating leases have on Verizon's balance sheet? Over the life of its leases, what effect does this lease classification have on net income?

There is no effect on the balance sheet and income statement as a result of the classification of leases.

Total assets and total liabilities are higher than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be equal to the interest and depreciation expense that the company would record under capital leases.

Total assets and total liabilities are lower than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be equal to the interest and depreciation expense that the company would record under capital leases.

Total assets and total liabilities are lower than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be greater than the interest and depreciation expense that the company would record under capital leases.

(c) Compute the present value of Verizon's operating leases, assuming an 5.01% discount rate and rounding the remaining lease term to 3 decimal places. (Use a financial calculator or Excel to compute. Do not round until your final answers. Round each answer to the nearest whole number.)

($ millions)	Present Value
Year 1	Answer
Year 2	Answer
Year 3	Answer
Year 4	Answer
Year 5	Answer
After 5	Answer
Total*	Answer

* (Use subsequent rounded answers for calculation.)

Which of the following statements best describes how we might use this additional information in our analysis of the company?

To assess the company's financial condition and performance, we might add the present value of its operating leases to both operating assets and nonoperating liabilities. No adjustment is necessary for the income statement.

To assess the company's financial condition and performance, we might add the sum of the contractual payments under the operating leases to both assets and nonoperating liabilities, and we can replace rent expense with the depreciation of the lease assets and the interest on the lease liability.

To assess the company's financial condition and performance, we might add the present value of its operating leases to both operating assets and nonoperating liabilities, and we can replace rent expense with the depreciation of the lease assets and the interest on the lease liability.

Verizon's balance sheet and income statement are prepared in accordance with GAAP. No adjustments are necessary to evaluate the financial condition of the company.

Answer 1

Part 1)

IRR is the minimum rate of return acceptable from a project. It can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic formula for IRR is given as follows:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5 + Cash Flow Year 6/(1+IRR)^6 + Cash Flow Year 7/(1+IRR)^7 + Cash Flow Year 8/(1+IRR)^8 + Cash Flow Year 9/(1+IRR)^9

The completed table is given as below (IRR is calculated with the use of EXCEL):

C D E F G H I J A 1 N 2 Amount 3 IRR B 0 -402 5.01%

where:

IRR = IRR(B2:K2) = 5.01%

_____

Part 2)

Total assets and total liabilities are lower than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be equal to the interest and depreciation expense that the company would record under capital leases. (which is Option C) [answer is self-explanatory in nature]

_____

Part 3)

The present value is determined as follows:

($ millions)	Present Value
Year 1	1,380
Year 2	1,193
Year 3	912
Year 4	663
Year 5	413
After 5	1,355
Total*	$5,916

______

Notes:

1) The present value for each year from Year 1 to Year 5 is calculated as below:

Year 1 = 1,449/(1+5.01%)^1 = $1,380

Year 2 = 1,316/(1+5.01%)^2 = $1,193

Year 3 = 1,056/(1+5.01%)^3 = $912

Year 4 = 806/(1+5.01%)^4 = $663

Year 5 = 527/(1+5.01%)^5 = $413

_____

The Present Value After 5 is arrived as follows:

Remaining Life = 1,937/527 = 3.676 (rounded to three decimal places)

Present Value after 5 = 527*PVIFA(5.01%,3,676)*1/(5.01%)^5 = 527*3.2831*0.7832 = $1,355 [here PVIFA indicates Present Value Interest Factor for an Annuity]

_____

Part 4)

To assess the company's financial condition and performance, we might add the present value of its operating leases to both operating assets and nonoperating liabilities, and we can replace rent expense with the depreciation of the lease assets and the interest on the lease liability. (which is Option C) [answer is self-explanatory in nature]