Leasing Connors Construction needs a piece of equipment that can either be lease

Question

Leasing

Connors Construction needs a piece of equipment that can either be leased or purchased. The equipment costs $200. One option is to borrow $200 from the local bank and use the money to buy the equipment. The other option is to lease the equipment. If Connors chooses to lease the equipment, it would not capitalize the lease on the balance sheet. Below is the company's balance sheet prior to the purchase or leasing of the equipment:

a. What would be the company's debt ratio if it chose to purchase the equipment? Round your answer to two decimal places.
_____%

b. What would be the company's debt ratio if it chose to lease the equipment? Round your answer to two decimal places.
_____%

Would the company's financial risk be different depending on whether the equipment was leased or purchased? Select one option from 1-5.

1. 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.

2. The company's financial risk (assuming the implied interest rate on the lease is equivalent to the loan) is greater if the equipment is purchased.

3. 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.

4. 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.

5. 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.

Current assets $350 Debt $500 Fixed assets 550 Equity 400 Total assets $900 Total liabilities and equity $900

Explanation / Answer

Formula of Debt Ratio = Total Liabilities / Total Assets

A) If the equipment is purchased, the company is going to borrow the required amount. Thus, assets (equipment) will increase by $200 and liabilities (bank borrowing) will increase by $200.

Debt ratio = ($200 + $350) / ($200 + $900)

= $550 / $1100

= 0.5 or 5% (Answer)

B) As the equipment lease will not be capitalized, the equipment will not be shown on asset side and lease liability will not be recognized on liabilities side of balance sheet. The lease payments will be adjusted as an expense in the Income Statement.

Therefore, the debt ratio in this situation will be:

Debt Ratio = $350 / $900

= 0.3889 or 38.89% (Answer)

Answer is:

III) The company's financial risk (assuming the implied interest rate on the lease is equivalent to the loan) is greater if the equipment is purchased.

Related Questions

Navigate

• Browse (All)
• Browse L
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.