20-1 Reynolds Construction needs a piece of equipment that costs $200. Reynolds either can 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. Reynolds’s balance sheet prior to the acquisition of the equipment is as follows: Current assets $300 Debt $400 Net fixed assets 500 Equity 400 Total assets $800 Total claims $800 a. (1) What is Reynolds’s current debt 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? b. Would the company’s financial risk be different under the leasing and purchasing alternatives?
20-2 Assume that Reynolds’s tax rate is 40% and the equipment’s depreciation would be $100 per year. If the company leased the asset on a 2-year lease, the payment would be $110 at the beginning of each year. If Reynolds borrowed and bought, the bank would charge 10% interest on the loan. In either case, the equipment is worth nothing after 2 years and will be discarded. Should Reynolds lease or buy the equipment?
20-3 Two companies, Energen and Hastings Corporation, began operations with identical balance sheets. A year later, both required additional manufacturing capacity at a cost of $50,000. Energen obtained a 5-year, $50,000 loan at an 8% interest rate from its bank. Hastings, on the other hand, decided to lease the required $50,000 capacity for 5 years, and an 8% return was built into the lease. The balance sheet for each company, before the asset increases, follows: Debt $ 50,000 Equity 100,000 Total assets $150,000 Total claims $150,000 a. Show the balance sheets for both firms after the asset increases and calculate each firm’s new debt ratio. (Assume that the lease is not capitalized.) b. Show how Hastings’s balance sheet would look immediately after the financing if it capitalized the lease. c. Would the rate of return (1) on assets and (2) on equity be affected by the choice of financing? How?