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.
| Year | Cash flows | IRR |
| 0 | -402 | 5% |
| 1 | 83 | |
| 2 | 71 | |
| 3 | 67 | |
| 4 | 63 | |
| 5 | 46 | |
| 6 | 46 | |
| 7 | 46 | |
| 8 | 69 |
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
| $ millons | Present value |
| Year 1 | 1379.87 |
| Year 2 | 1193.42 |
| year 3 | 911.95 |
| year 4 | 662.85 |
| year 5 | 412.72 |
| year 6 | 1444.59 |
| Year 6 | 5288.39 |
|
11293.80 |
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
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