Reynolds Construction needs a piece of equipment that $200. Reynolds either can

Question

Reynolds Construction needs a piece of equipment that $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’ balance sheet prior to the acquisition of the equipment is as flows: Current Assets $300 Debt $400 Net fixed assets $500 Equity 400 Total assets $800 Total Claims $800 a. 1 What is Reynolds 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?

Explanation / Answer

a. (1) Reynolds’ current debt ratio is $400/$800 = 50%. 2) The company balance sheet looks like after equipment purchase Current assets---------------------$300 Fixed assets------------------------$500 Leased equipment----------------$200 Total assets------------------------$1,000 Debt (including lease)-------------------$600 Equity-------------------------------------$400 Total claims------------------------------$1,000 Therefore, the company’s debt ratio = $600/$1,000 = 60%. 3) If the company leases the asset and does not capitalize the lease, its debt ratio = $400/$800 = 50%. b) 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.

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