Q:

At the beginning of the year, ABC Corp. began to lease a major piece of equipment. The lease payment is $10,000 per year. However, using a discount rate of 15%, ABC's management computed the present value of this lease obligation to be $35,000. If the equipment is depreciated by a rate of $7,000 per year, and the firm uses the capitalized lease method, how much reduction in pretax income will the leasing of this equipment result in during its first year?
A) $12,250
B) $5,250
C) $10,000
D) $ 7,000

A:

The correct answer is: A)
Under the capitalized lease method, the lessee must treat the asset as if it was purchased with the use of debt financing. Therefore, the lessee must record a depreciation amount to account for the asset, and an interest expense to account for the debt. Therefore, total recorded expenses are $7,000 + [15% of $35,000] = $12,250. Thus, this is also the amount by which pretax income will be lowered.


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