Name: Rudy AlvarezProblem Set 5Due on or before Day 6
(Monday)Assigned Problem 1Reynolds Construction needs a piece of
equipment that costs $200. Reynolds 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.
Reynolds s balance sheet prior to the acquisition of the equipment
is as follows:Current assets300Debt400
Fixed assets500Equity400
Total assets800Total claims800
a. What is Reynoldss current debt ratio?$400/$800= 50%b. What
would the companys debt ratio be if it purchased the
equipment?Current assets $300Fixed assets $500Leased equipment
$200Total assets$1000
Debt including lease$600Equity$400Total claims$1,000
Debt ratio after purchasing equipment: $600/$1000= 60%
c. What would the companys debt ratio be if the equipment were
leased?$400/$800=50%
d. Would the companys financial risk be different under the
leasing and purchasing alternatives?The financial risk would be no
different under a lease or a purchase if the interest rate on the
lease is equivalent to the loan.
Other financial risk considerations include whether the lease is
an operating lease or a financial lease. If it is an operating
lease, it usually means that maintenance is included and
cancelable. If there are high costs to the repairs of the equipment
and the equipment is only needed over the short term there may be
an incentive to pursue this route versus a purchase which would
mean that the company is now responsible for the maintenance and
service of that equipment. Especially if those maintenance and
service costs are especially high those are considerations that the
company should take into account after determining the break-even
point and time frame analysis.
Assigned Problem 2Delmont Transport Company (DTC) is evaluating
the merits of leasing versus purchasing a truck with a 4-year life
that costs $40,000 and falls into the MACRS 3-year class. If the
firm borrows and buys the truck, the loan rate would be 10%, and
the loan would be amortized over the truck's 4-year life, so the
interest expense for taxes would decline over time. The loan
payments would be made at the end of each year. The truck will be
used for 4 years, at the end of which time, it will be sold at an
estimated residual value of $10,000. If DTC buys the truck, it
would purchase a maintenance contract that costs $1,000 per year,
payable at the end of each year. The lease terms, which include
maintenance, call for a $10,000 lease payment at the beginning of
each year (i.e. 4 payments total). DTC's tax rate is 40%. What is
the net advantage to leasing? (Note: Assume MACRS rates for Years 1
to 4 are 0.3333, 0.4445, 0.15, and 0.07.)CostMACRS
ratesDepreciation per year
$40,0000.3333$13,332 (year 1)
$40,0000.4445$17,780 (year 2)
$40,0000.15$6,000 (year 3)
$40,0000.07$2,800 (year 4)
PurchasingYEARInstallmentDepreciationTax benefit on
depreciationMaintenance contract/yrCash flowPresent value factor at
10%PV of Cash flow
1$12,174$13,332$5,333$1,000$7,841 0.91$7,128
2$12,174$17,780$7,112$1,000$6,0620.83$5,010
3$12,174$6,000$2,400$1,000$10,7740.75$8,095
4$12,174$2,800$1,120$1,000$12,0540.68$8,233
salvage value, year 4(10,000)0.68(6,830)
PV Total cash flows$21,636
LeasingYEARLease paymentTax benefit on leaseCash flowPresent
value factor at 10%Present value of cash flow
1$10,000$4,000$6,0000.91$5,455
2$10,000$4,000$ 6,000 0.83$4,959
3$10,000$4,000$6,0000.75$4,508
4$10,000$4,000$6,0000.68$4,098
PV Total cash flows$19,020
The present value cash flow for purchasing the truck is $21,636
and for leasing is $19,020. The net advantage to leasing is
$2,616
