Analysis Case 15-1

1. When Wal-Mart’s management says “Unrecorded Contractual Obligations,” it is referring to the fact that when assets are acquired under operating leases, accounting standards do not require the lessee to record a liability as would be the case under a capital lease. Thus the financing escapes the balance sheet. Most of Wal-Mart’s leases do not meet any of the four classification criteria that would cause the lease to be capitalized.

2. Answers to requirements 2 through 4 will vary depending on the date of the financial statements accessed. The analysis, though, should be the same regardless of the dates. The following is based on the statements for the fiscal year ending January 31, 2009.

Note 9: “Commitments” indicates that: the present value of net minimum lease payments for capital lease obligations was $3,515,000,000.

3. If the operating leases were capitalized, the capital lease liability would increase by approximately a multiple of about 2.33. Note 9 below indicates that future minimum lease payments under operating leases are about 2.33 times higher than for capital leases (12,830 / 5,518). Assuming comparable discount rates and timing of payments, the present value of future minimum lease payments for operating leases would be about: $3,515,000,000 x 2.33 = $8,190 million. Of course, we could also make some reasonable assumptions about discount rates and the timing of payments and estimate the present value of all future payments to be made on the operating leases as we did in the “Decision-Makers’ Perspective” section at the end of the chapter. Results should be comparable. In either case, we have a rough estimate.

Case 15-1 (continued)

9 Commitment (in part)

Aggregate minimum annual rentals at January 31, 2009, under non-cancelable leases are as follows:

(Amounts in millions) Operating Capital

Fiscal Year Leases Leases

2010 $ 1,161 $ 569

2011 1,138 556

2012 997 527

2013 888 492

2014 816 460

Thereafter 7,830 2,914

Total minimum rentals $12,830 $5,518

Less estimated executory costs 47

Net minimum lease payments 5,471

Less imputed interest at rates ranging from 3.0% to 13.6% 1,956

Present value of minimum lease payments $3,515

Case 15-1 (concluded)

4. In general, debt increases risk. Debt places owners in a subordinate position relative to creditors because the claims of creditors must be satisfied first in case of liquidation. Also, debt requires payment, usually on specific dates, and failure to pay interest and principal may result in default and perhaps even bankruptcy. The debt-to-equity ratio, total liabilities/shareholders’ equity, frequently is calculated to measure the degree of risk. Other things being equal, the higher the ratio, the higher the risk. The debt to equity ratio for Wal-Mart is:

[$163,429 – 65,285] ÷ $65,285 = 1.5

If debt is increased by $8,190 million from capitalizing operating leases, the debt to equity ratio increases to 1.63:

([$163,429 – 65,285] + 8,190) ÷ $65,285 = 1.63

As shown in the chapter, adding the assets from capitalizing operating leases also causes the return on assets to decline. Analysts and management should be alert to the off-balance-sheet effect of operating leases. Remember, though, debt also can be an advantage. Debt can be used to enhance the return to shareholders. If a company earns a return on borrowed funds in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone. This desirable situation is called “favorable financial leverage.”

Research Case 15-2

Requirement 1

After the first full year under the warehouse lease, the balance in Dowell’s lease liability is $30,816,422. This is the balance after reductions from the first five quarterly lease payments as shown in this amortization schedule. (The first payment was at December 31 of the previous year, the inception of the lease.)