ABC Co.is a large retail department store that has stores in all the major shopping centers in U.S. It has operating leases on the floor space for most of these stores. The income statements of ABC Co. show that its current operating lease expense is $100 million and its operating income is $1,000 million. ABC Co. has the operating lease commitments of $520 million from 2021 to 2023. For the three years after 2024 the operating lease commitments will be $500 million. The book value of ABC Co.s interest bearing debt is $2,000 million and its pre-tax cost of debt is 15% and cost of equity is 12%.

a. Explain how the existence of these operating lease expenses will mean that the actual earnings of ABC Co. are different from the earnings reported in their financial statements.

b. Estimate the total present value in 2020 of all ABC Co.'s operating lease commitments.

c. Show how ABC Co.s book value of debt, operating income, and cost of capital will need to be adjusted.

d. ABC Co. spends a considerable amount each year on advertising costs. Explain how these can affect the actual earnings of ABC Co. and describe any adjustments that should be made.

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