Question

Problem 19-01
Balance Sheet Effects

Reynolds Construction (RC) needs a piece of equipment that costs $300. RC can either lease the equipment or borrow $300 from a local bank and buy the equipment. If the equipment is leased, the lease would not have to be capitalized. RC's balance sheet prior to the acquisition of the equipment is as follows:

Current assets	$250		Debt	$450
Net Fixed assets	500		Equity	300
Total assets	$750		Total claims	$750

1. 1. What is RC's current debt ratio? Round your answer to two decimal places.
      %
      
   2. What would be the company's debt ratio if it purchased the equipment? Round your answer to one decimal place.
      %
      
   3. What would be the debt ratio if the equipment were leased? Round your answer to two decimal places.
      %
   
   
2. Would the company's financial risk be different under the leasing and purchasing alternatives?
   I. The company's financial risk (assuming the implied interest rate on the lease is greater than the interest rate on the loan) is no different whether the equipment is leased or purchased.
   II. The company's financial risk (assuming the implied interest rate on the lease is less than the interest rate on the loan) is no different whether the equipment is leased or purchased.
   III. The company's financial risk (assuming the implied interest rate on the lease is equivalent to the loan) is no different whether the equipment is leased or purchased.
   IV. The company's financial risk (assuming the implied interest rate on the lease is equivalent to the loan) is greater if the equipment is leased.

I, II, III, or IV?

Answer 1

a). 1). Debt Ratio = Debt / Total assets = $450 / $750 = 0.6, or 60%

2). New Debt Ratio = [$450 + $300] / [$750 + $300] = $750 / $1,050 = 0.7143, or 71.43%

3). Since the leased equipment does not have to be capitalized when leasing, the debt ratio remains the same.

b). This is a loaded question due to the fact that we do not know several of the factors involved in the loan such as the interest rate of the loan, the life of the equipment, or the number of years of the loan, but in principle there really is no difference in financial risk to the company between purchasing or leasing the equipment. Obviously there is always a risk when adding debt to a company, but in the case of this problem, I am operating under the assumption that the interest rate of the loan is virtually the same as the interest rate associated with leasing the equipment. If this is not is no added risk.