Bundled leases and related earnings quality and ethical issues for Xerox Corporation.

Assume that Xerox enters into a seven-year lease with Ford Motor Company for a constellation of copying equipment. The lease requires Ford to pay to Xerox $14,816.12 at the end of each of the seven years following the date of Xerox's delivering and installing the equipment on Ford premises. The copying equipment cost Xerox $23,000 to manufacture.

The lease requires that Xerox will provide Ford with on-site emergency service and regular maintenance at no cost additional to the annual payment. Such service contracts ordinarily cost

$2,000 per year. The lease requires that Xerox will provide Ford with all toner and other supplies at no cost additional to the annual payment. Such supply contracts ordinarily cost the user

$1,200 per year, if the user purchases these separately. Assume, unrealistically, that firms would make these payments at the end of the year.

Because Xerox cannot readily establish the stand-alone sales price of the equipment in comparable transactions, it cannot make a direct estimate of the revenue for the equipment element of its bundled leases. Instead, Xerox directly estimates the financing revenues. To this end, Xerox developed procedures to measure the fair value of the financing revenue included in its total revenue from bundled leases. Xerox has estimated from publicly available data that Ford Motor Company ordinarily must pay 15 percent per year, compounded annually, to finance over seven years any purchases for equipment being leased.

a. Compute the amount of each payment attributable to the equipment and financing, combined.

b. Compute the present value of Xerox's collections attributable for the equipment and financing, combined.

c. Construct an amortization schedule to allocate the total receipts for equipment and financing into those two components. Use the 15 percent rate suitable for Ford. What is total interest revenue for the 7 years?

d. Compute Xerox's gross profit from the equipment on signing the lease.

e. If Xerox were to estimate a lower interest rate for Ford, but all the other data remain unchanged, would Xerox's gross profit recognized at the time the lease begins increase or decrease?

f. Re-do parts c and d using a 1 2 percent rate as suitable for Ford. If you do the computations correctly, you will see that gross profit increases by 18.5 percent, which meant several hundred million dollars of income in the case of Xerox.

g. What ethical issues might accompany Xerox's estimation of Ford's borrowing rate? How do these estimates affect Xerox's quality of earnings?