A corp. is evaluating whether to lease or purchase needed equipment at a cost of
ID: 2665611 • Letter: A
Question
A corp. is evaluating whether to lease or purchase needed equipment at a cost of $10,000. If the equipment is leased, the lease would not have to be capitalized. The company's balance sheet prior to the acquisition of the equipment is as follows:equipment cost 10,000
current assets 50,000 debt 35,000
net fixed assets 40,000 equity 55,000
total assets 90,000 total claims 90,000
a. calculate current debt ratio
b. calculate debt ratio if they purchase
c. calculate debt ratio if they lease
d. will companies ROA and ROE be affected by its decision to lease or purchase. Why
e. what factors should they consider in coming to its decision other than net advantage to leasing. why?
Explanation / Answer
a)
Current debt ratio = debt / current assets
= 35,000 / 50,000
= 0.7%
(b)
Debt ratio if they purchase = debt / total assets
= 35,000 / 90,000 + 10,000
= 35,000 / 100,000
= 0.35
Note:-
If the purchase the total assets will increase 10,000 (equipment cost 10,000) so total assets will increase to 90000 + 10000 = 100,000
(c)
Debt ratio if they lease = debt / total assets
= 35,000 / 90,000
= 0.38
(d)
This all depends on if the lease expense incurred to lease an item is different than the interest that would be incurred to purchase it when added to the deprecation expense that would be taken against a purchased item.
Basically, if the lease expense (in the case of a lease) is different than the combined interest and depreciation expense (in the case of a purchase), then the firm's net income will be different in the two cases, and this will effect both the ROE and ROA measures.
In general, we would expect the lease expense to be different from the combined depreciation and interest expense, so yes, it would be expected that the lease vs. buy decision would impact both ROE and ROA.
(e)
There is not a simple, one-size-fits-all answer to this question because there are many factors that need to be taken into consideration.
Cash flow is the first and the most important factor for making a decision, but you rarely see the buy/lease analysis laid out this way. Many business publications have run stories that conclude that leasing always costs more, but that may not be true. These analyses consistently leave out a crucial step: calculating the returns if the business owner invests the cash flow savings from leasing. Of course, if you leave out that all important element of the equation, leasing will always look more expensive in the long run.
There are some other factors to consider in whether or not you should buy or lease.
Leasing Benefits
Leasing may permit you to more easily keep up to date with technology and this could be very important. If your business relies heavily on computer technology, for example, acquiring cutting-edge gear is a competitive advantage. Leasing is also more flexible. For example, if you lease a copier for two years, when the lease expires you can get a larger one if your needs have grown. You will also be able to get the latest bells and whistles if you need them. Plus, the burden of getting rid of the equipment falls to your leasing company. Got any old equipment you don’t use lying around the office?
Other benefits include no need for large upfront cash payments, which preserves working capital for your business. You will pay a security deposit and may be required to make several monthly payments at the start of the lease, however
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