Question

Balance Sheet Effects

Reynolds Construction (RC) needs a piece of equipment that costs $150. RC can either lease the equipment or borrow $150 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	$200		Debt	$350
Net Fixed assets	600		Equity	450
Total assets	$800		Total claims	$800

Please answer the following.

A.

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.
______%

B.

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 equivalent to 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 equivalent to the loan) is greater if the equipment is leased.
III. 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.
IV. 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.

Answer 1

Answer A
1) RC's current debt ratio = Total Debt / Total assets = $350 / $800 = 43.75%
2) RC's debt ratio if it purchased the equipment = [$350+$150] / [$800+$150] = 52.63%
3) RC's debt ratio if the equipment were leased = $350 / $800 = 43.75%
Answer B
The answer is Option I.
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.
Note :
The lease in a question is an operating lease a company do not capitalise the lease payments.
Operating lease is a contract that allows for the use of an asset but doesn't convey rights of ownership of
the asset.An operating lease is an off balance sheet financing of assets where a leased asset and associated
liabilities of future lease payments are not included on the balance sheet of a company.