Question

On October 10, 2010, Pear Company completed negotiations on a contract for the purchase of new equipment. Under the terms of the agreement, the equipment may be purchased now or Jar may wait until January 10, 2011, to make the purchase. The cost of the equipment is $800,000. It will be financed by a note bearing interest at the market rate. Straight-line depreciation over a 10-year life will be used for book purposes. A double-declining balance over seven years will be used for tax purposes. (One-half year of depreciation will be taken in the year of purchase regardless of the date of purchase.)

Required:

a)    Discuss the financial statement impacts of postponing the purchase of the equipment. Would the market price of the firm’s common stock be affected by any or all of these impacts? Do not assume in your discussion that the postponement will affect revenues or any operating costs other than depreciation.

b)   Discuss any cash flow impacts related to postponing the purchase of the equipment.

c)    Efficient markets assume that stockholder wealth is affected by the amount and timing of cash flows. Which alternative is more favorable to them: Purchasing before year-end or waiting until January? Explain your answer.

Answer 1

a) The financial impact for postponing of purchase of the equipment would be that with purchase of the machinery the company might be able to generate new cashflows so there would be impact of cash inflow, also there would be tax savings on interest and depreciation on purchase of machinery. This will lead to increase in fixed assets and increase in liabilities. The market price would not be impacted by any or all of these impacts.

b) The cash flow impacts might be the propose revenue the company would earns, also there would be tax savings on interest and depreciation

c) Purchasing before year-end is a better option since the stockholder wealth is affected by the amount and timing of cash flows. The cash flow earned later and purchasing done in January will have impact of time value of money and inflation