Problems - Ch. 11
12.{S} Aluminum producers that have take-or-pay contracts for energy
and/or bauxite have converted significant variable costs into
fixed costs. Therefore, their marginal costs are much lower than
if these contracts had not been entered into. Under these
conditions, aluminum producers will continue production as long
as revenue exceeds marginal costs, even though they lose money
based on total costs.
15 (M)A.
(i)
Computation
interest expense:
of
implicit
interest
rate
using
1995
Year ending December 31, 1995 ($ in millions)
Minimum lease payment (MLP) for operating leases
Less: Current portion of lease obligation
Equals: Interest component
Present Value of minimum lease payments
Therefore, Interest rate = $12 / $94 = 12.77%
(ii) Computation of implicit interest rate
using the minimum lease payments over the lease term:
Reported MLPs
1995
$ 20
1996
16
1997
11
1998
11
1999
11
Remainder
104
Total
$173
PV of MLPs
$ 94
From the year 2000 on, we assume that the MLPs equal
the 1999 MLP of $11 million. You may use a declining
rate assumption. However, note that the 1997-1999
payments are stable at $11 million a year. Also, the
Box 11-2 illustration of AMR Corp.'s operating leases
shows that the use of the declining rate produced a
difference of only 3% in computed present values.
The
constant
rate
assumption
implies
an
additional 9 payments of $11 million each and a final
payment of $5 million for the last year. This payment
pattern and the reported present value of $94 million
suggest an interest rate of 10.12%. Footnote 20
includes executory costs of $7 million in the total
MLPs of $173 million. The implicit interest rate is
9.29% if we gross up the reported present value of
$94 million to account for the executory costs.
Solutions Chapter 11 - P. 1
$ 20
8
$ 12
94
B.
Interest rate implicit in the capital leases based on:
(i)
1995 interest expense
12.77%
(ii) MLPs
over
the
life
of
10.12% (or 9.29%, see part (A))
the
lease
Using 1995 interest expense ignores the steep decline in
MLPs over the lease term. Footnote 20 shows a decline of
25% from $20 million to $16 million in 1996 and a decrease
of more than 31% in 1997 followed by equal payments in 1998
and 1999. When first year MLPs are significant, the timing
of lease payments can distort these computations. Use of a
declining rate assumption and consideration of executory
costs would produce a lower interest rate.
C.
Operating Leases
Reported MLPs
1995
1996
1997
1998
1999
Remainder
Total MLPs
$ 290 million
224
182
156
124
673
$ 1,649 million
The constant rate assumption gives us five more payments
equal to the 1999 payment of $124 million and a final
payment of $ 53 million. The present value of the operating
lease MLPs at 12.77% is $980 million.
D.
Exhibit 4.7 (page 164) contains the 1990-1994 duPont
long-term debt and solvency analysis. Summarized 1994 data
follow:
Capitalization Table
Reported
$ 7,668
Reported total debt
PV of operating lease
Adjusted total debt
980
$ 8,648
Reported total equity
Total capital
EBIT
Interest expense
Interest
leases
on
PV
of
Ratios
Debt to equity
Debt to capital
Times interest earned
Adjusted
12,822
20,490
4,941
703 Includes
capitalized interest
operating
21,470
5,066 (4,941+125)
828 (703+125)
125 (.1277 x 980)
0.60 (7,668/12,822)
0.37 (7,668/20490)
7.03 (4,941/703)
0.67 (8,648/12,822)
0.40 (8,648/21,470)
6.12 (5,066/828)
The addition of the PV of operating lease payments shows the higher
leverage and lower interest coverage relative to reported data.
Solutions Chapter 11 - P. 2