Answer (D) is correct.
A capital lease is one in which many of the benefits and risks of
ownership are transferred to the lessee. For accounting purposes, the
lessee treats a capital lease as similar to the purchase of an asset. If the
present value of the minimum lease payments (excluding executory
costs) is 90% or more of the asset’s fair value, the lease should be
accounted for as a capital lease. Given that the executory costs associated
with the lease are to be paid by the lessor, a portion of the lease rental price is for those costs, not for the asset. Executory costs include
insurance, maintenance, and similar expenses. Consequently, the annual
minimum lease payment equals the annual payment minus the executory
costs, or $3,500 ($4,000 yearly rental – $500). The present value of the
minimum lease payments is therefore $9,590 ($3,500 × 2.74), which is
greater than 90% of the fair value of the asset. Thus, the lease should be
capitalized. The appropriate amount of the initial asset value is the
present value of the minimum lease payments calculated above.