[Anonymous]

Power Station

Power Station is contemplating entering into a leasing arrangement with Energy Corporation. (Energy Corporation is not related to Power Station.) The arrangement would involve the lease of turbines at a power plant. For regulatory purposes, Power Station is required to purchase and take title to the turbines. Therefore, the transaction would be structured such that Power Station will purchase the turbines from a third party and immediately sell the turbines to Energy Corporation. Energy Corporation will then take title from Power Station. Simultaneously, Energy Corporation will lease the turbines back to Power Station under an operating lease agreement. Power Station’s intent in entering into the arrangement is to obtain off-balance sheet treatment for the assets and related financing.

The total purchase price (fair market value) of the turbines, including installation costs, will be $100 million. Energy Corporation will obtain the purchase price through non-recourse notes with financial institutions.

The principal terms of the lease agreement include (1) a lease term of five years, (2) a fixed rent in an amount sufficient to pay the principal and interest on the notes, and (3) a purchase option to acquire the equipment at fair market value at the end of the lease term.

The lease agreement (1) does not transfer ownership to Power Station by the end of the lease term, (2) contains no bargain purchase option, (3) is for a term less than 75 percent of the economic life of the equipment, and (4) states that the present value of Power Station’s minimum lease payments is less than 90 percent of the current fair value of the equipment.

Power Station is responsible for (1) all expenses related to the delivery and installation as of lease inception; (2) repair and maintenance during the lease term; (3) deinstallation, shipping, and installation at a new location; and (4) repair of the power plant at the end of the lease term. The estimated cost to remove the equipment after installation (estimate is as of the beginning of the lease term) is $7 million, which includes $5 million to repair damage to the power plant as a result of the removal. The estimated cost to ship and reinstall the equipment at a new site (estimated as of the beginning of the lease term) is $7.3 million.

Required:

• How should Power Station account for the lease of the turbines from Energy Corporation?

• Indicate present value of the equipment.

I do not understand this problem…