In our Anderson Company example, we assumed that the lease could not be canceled. What effect would a cancelation clause have on the lessee’s analysis? On the lessor’s analysis?

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In our Anderson Company example, we assumed that the lease could not be canceled. What effect would a cancelation clause have on the lessee’s analysis? On the lessor’s analysis?

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In our Anderson Company example, we assumed that the lease could not be canceled. What effect would a cancelation clause have on the lessee’s analysis? On the lessor’s analysis?

Explanation & AnswerSolution by a verified expert

Explanation

With the inclusion of the cancellation clause in the lease agreement, risk in case of lessee will decrease as he can cancel the agreement as per their own motion whenever the equipment is not performing well or the conditions of the lease are not suitable. The discount rate will then increase to adjust the risk in the agreement and that increased discounting rate will decrease the present values of estimated cash flows of the lease.
However, the inclusion of cancellation clause in the agreement will increase the risk of lessor as the lessee can cancel the agreement anytime which may harm the estimated receipts of lessor from the lease agreement. The discount rate should be increased to adjust the higher risk in the agreement and the increased discounting rate will lower the present values of estimated cash flows while doing financial analysis.
Therefore, the cancellation clause affects the analysis of risk and discount rate of both the lessor and the lessee, but in an opposite way.

Verified Answer

A cancellation clause in the lease agreement reduces the risk of the lessee as the lessee can cancel the agreement anytime during the lease term. The reduced risk is adjusted in the discounting rate by way of rate enhancement, which in turn alters the actual present value of cash flows from the agreement.
However, the cancellation clause enhances the risk of lessor as the lessee can cancel the lease anytime during the agreement and the expected returns of lessor from the periodic payments of lease rentals got affected. The enhanced risk will make the lessor alter his analysis of discount rate, in order to  increase the discounting rate.

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