Lease accounting at Metro AG

Metro AG is one of the world’s largest discount retailers. Headquartered in Germany, its activities are segmented as follows:

Cash and carry (47%): Food and nonfood products at wholesale prices, primarily to business customers, under the Metro and Makro store brands.
Hypermarkets and supermarkets (21%): Food products under the Extra store brand and, in hypermarkets, food and nonfood products under the Real store brand.
Specialty stores (25%): Two chains in this group, Media Markt and Saturn, offer electronic products, and the other, Praktiker, specializes in the home improvement market.
Department stores (7%): A variety of household and clothing products in more upscale shopping environments under the Kauflof store brand.
Metro generates about 53% of its sales within Germany, 45% from the rest of Europe, and 2% from elsewhere. Revenues were €53.5 billion in 2004.

Most of its nearly 4000 stores worldwide are leased. Some of these leases are capitalized (i.e., the present value of future lease payments appear on the balance sheet), but most are not.

Metro’s 2004 annual report reveals the following information:

Capital leases at the end of 2004 had a present value of €2090 million. Minimum payments required in 2005 are €280 million. The weighted-average interest rate for these leases was 6.1%.
As of the end of 2004, minimum payments required under operating leases were €1182 million for 2005, €4234 million in total payments over the next four years (2006–2009), and €5548 million in total payments for 2010 and beyond.
shareholders equity at the end of 2004 was €4739 million, debt was €9506 million, and invested capital was €14 245 million.
Metro reported the following results in 2005:

Revenues were €55.7 billion.
Net operating profit after tax (NOPAT) was €1368 million, based on a tax rate of 30%.
Net income was €649 million.
Cash flow from operations was €2.2 billion in 2005, down from €2.9 billion in 2004 and €3.1 billion in 2003.

Note: Round all euro amounts to the nearest million.

(a) What reasons can you give for why Metro relies so extensively on leasing?

(b) Prepare the journal entry to record cash payments under capital leases for 2005.

(c) Prepare the journal entry to record cash payments under operating leases for 2005.

(d) Using the year-end 2004 figure for invested capital, estimate ROIC for 2005.

(e) Calculate the present value of Metro’s operating leases as of the end of 2004. For your calculations, assume that (1) the lease payments are made at the end of each year, (2) the implicit weighted-average interest rate for the leases is 6%, (3) payments for 2006 through 2009 are made evenly throughout the period (i.e., lease payments are the same in each year), and (4) payments in 2010 and beyond are made evenly over the next 10 years.

(f) Give the journal entries to convert the operating leases into capital leases as of the end of 2004, and account for them as capital leases in 2005. Assume an amortization period of 15 years.

(g) Reestimate NOPAT for 2005 after accounting for the operating leases as capital leases.

(h) Reestimate ROIC, after accounting for the operating leases as capital leases.

(i) What effect will capitalization of the operating leases have on cash flow from operations?

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