Question

Vanlu Construction needs a piece of equipment that costs $200. Vanlu can either lease the equipment or borrow $200 from a local bank and buy the equipment. If the equipment is leased, the lease would not have to be capitalized. Vanlu’s balance sheet prior to the acquisition of the equipment is given in the table below.

Current assets $400 , Net fixed Assets $400, Total assets= $800.

Debt $300, Equity $500, Total claims= $800.

1) What is Vanlu’s current debt ratio (i.e., debt-to-assets ratio)?

2) What would be the company’s debt ratio if it purchased the equipment?

3) What would be the debt ratio if the equipment were leased?

4) Would the company’s financial risk be different under the leasing and purchasing alternatives?

Answer 1

1) Debt Ratio = Total Debt / Total Assets

                    = $300 / $800

                   = 0.375

2) If the equipment is purchased, then there will addition in the debt of $200 and addition in the asset of $200.

                 = $500/ $ 1,000

                = 0.5

3) If the equipment is leased, the same will be treated as operating lease and the amount will be charged as expense in the income statement and there will be no change in the balance sheet. The Debt ratio will remain the same as in 1) above.

                  = $300 / $800

                   = 0.375

4) Under the leasing option, company will not have any financial risk since the amount spent on lease will be treated as expense in income statement and there will not be any requirement to pay additional interest for the debt taken from bank. However, if the company chooses purchasing alternative, this will mean, the debt ratio of the company will increase and it will have to bear the interest payment as well leading to a bit higher financial risk that leasing alternative.