Connors Construction needs a piece of equipment that can either be leased or pur

Question

Connors Construction needs a piece of equipment that can either be leased or purchased. The equipment costs $250. One option is to borrow $250 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:

$650

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.

%

Current assets $250 Debt $350 Fixed assets 400 Equity 300 Total assets $650 Total liabilities and equity

$650

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 $250 and liabilities (bank borrowing) will increase by $250.

Debt ratio = ($350 + $250) / ($650 + $250)

= $600 / $900

= 0.6667 or 66.67% (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 / $650

= 0.5385 or 53.85% (Answer)

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