Pdq Management Accounting Case

memorandum

INTRODUCTION

To keep up with growing demand, PDQ wishes to expand their current fleet by 200 trucks. In addition, they are also looking to replace 200 trucks that will be coming to the end of their useful lives over the next two years. As your current concern is to find the most sensible way to finance these purchases, the purpose of this memo is to analyze the 2 leasing options outlined for the 400 trucks needed and compare them to buying the 400 trucks outright at current fair value. The options are outlined further below:

1)        Lease the vehicles with short-term leases, lasting 1 year. For a truck with a cost of $80,000, the annual payments would be $15,000, due in advance (payments due in the beginning of each period)

2)        Lease the vehicles with long-term lease that last for 10 years (the entire expected useful life). For a truck with a cost of $80,000, the annual payments would be $11,000. These leases would transfer title and all benefits to PDQ at the end of the lease

3)        Purchase the vehicles by borrowing from the bank at 9% quoted rate

The alternatives will be evaluated based on the present values of total option expenses and the financial statement effects.

To summarize and assess PDQ’s current financial standing:

-        $32M in Total Assets, $19M in Total Liabilities

o        Debt to Asset = 0.5938

o        Debt to Equity = 1.4615

-        Interest rate (average) for on the balance sheet debt = 7%

-        Interest rate for additional borrowing = 9%

Note: For simplicity, let us assume that all 400 trucks will be leased at the beginning of Year 1 and that both leasing options require advance payment (since it is not specified for Option 2)

OPTION 1

To assess the affect Option 1 will have on PDQ’s financial statements, we must classify the lease to determine its accounting treatment under IFRS. To do this, we will assess the lease against the 3 criteria below:

Criteria:

• Transfer of Ownership? None
• Coverage of major part of useful life → 1 year lease vs 10 years of useful life, does not cover major portion of life
• PV of MLP is not substantially all the fair value ($15,000 due in advance, calc below)
• Fair Value = 80,000 x 400 = $32 million

Therefore, this option would be classified as an operating lease as it doesn’t transfer all risks and rewards to PDQ, the term length of the lease accounts for 10% of the truck’s useful life and the present value of the minimum lease payments for a 1 year lease paid in advance would simply equal the lease payments per year: $15,000. Therefore, PDQ’s overall increase in expenses per year is $15,000 x 400 trucks = $6 million.

The journal entry required for PDQ to make each year would be as follows (assuming PDQ makes the lease payments in cash):

                         Dr. Operating Lease Expense              $6,000,000

         Cr. Cash                                     $6,000,000

Balance Sheet Effects

Due to the off-balance-sheet financing of the operating lease, PDQ can avoid reporting the lease obligations, which allows the company to maintain a low leverage ratio. After the first year, if the company leases 400 vehicles, the firm will use up $6 million of its cash to do so, decreasing its equity via recording lease expenses for the same amount.

No depreciation expense is recorded as this is an operating lease and all depreciation will be recorded on the books of the lessor.

Income Statement Effects

As mentioned above, the company will incur $60 million worth of lease expenses over the next 10 years if they finance the vehicles using the this option. The additional expense will $6 million for the next 10 years.

However, to adequately compare the options we must see the present value of the same cash flows at PDQ’s borrowing rate to see what the opportunity cost is. The calculations are as follows:

PV of Cash Flows

Year 1 – 10: $15,000 x 400 trucks = $6 million every year

6 million x (1+PVAF (9%,9))

= $6 million x 6.9952

= $41,971,200

If we compare this to the fair value for the 400 trucks at $80,000 each, we can see that this option is more expensive for PDQ.

Lastly, we also must determine the implicit interest rate the lessor used to determine their $15,000 lease payment. As is seen in the calculation below, the 17.78% implicit rate is much higher than the 9% additional borrowing rate. This further supports that this option is more expensive for PDQ compared to buying the trucks outright.

Implicit Rate Calculation

OPTION 2