The Bear Minimum

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Per your request, our group conducted research to determine whether costs or potential costs of the provisions of Big Bear Power’s lease of Goliath Co’s combustion turbine should be included in its minimum lease payments. We have provided a summary of the facts, our conclusion, the basis for our conclusion, and an analysis of possible alternatives to our conclusion as requested.

Summary of the Facts
Big Bear Power (the Company), a public utility company, is leasing a combustion turbine from Goliath Co. for a 10-year, non-cancelable term. The lease agreement was signed on December 15, 2004, and the company’s right to use the turbine starts on January 1, 2005. Big Bear Power has been financially strong for a number of years, has positive cash flow, and is in accordance with all of its debt covenants. The lease agreement contains three provisions, each of which has associated costs that may potentially need to be included in the calculation of minimum lease payments. The issue at hand is determining whether the costs in these provisions should, in fact, be included in minimum lease payments

Provision 1
Big Bear Power should not include the $500,000 negotiation fee in its minimum lease payments because, by definition, it is not an obligatory payment to be made toward the asset. On the other hand, the Company should include the $1 million legal fee in minimum lease payments since it is considered an initial direct cost made in connection with the leased property.

Provision 2
The lease agreement includes a provision requiring a penalty payment if Big Bear’s bank declares it in default under its primary credit arrangement. This potential cost should be included in calculating minimum lease payments since a lack of predetermined criteria exists to determine default.

Provision 3
The lease agreement stipulates Big Bear’s annual lease amount to be increased by the percentage increase in the Consumer Price Index (CPI). Because the lease...
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