Hack Wellington Company needs equipment that will cost the company $900. Hack We

Question

Hack Wellington Company needs equipment that will cost the company $900. Hack Wellington Company is considering to either purchase the equipment by borrowing $900 from a local bank or leasing the equipment. Assume that the lease will be structured as an operating lease. Some data from Hack Wellington Company's current balance sheet prior to the lease or purchase of the equipment are: The company's current debt ratio is___________. If the company purchases the equipment by taking a loan, the total debt in the balance sheet will________, and the debt ratio will change to_______. If the company leases the equipment, the company's debt ratio will___________because the lease is not capitalized. In this case, the company's financial risk will be__________under a lease agreement as compared to the financial risk in purchasing the equipment by taking a loan. However, if the lease is capitalized, the financial risk under the lease agreement will be__________as compared to the risk in buying the equipment.

Explanation / Answer

Solution 1

Debt ratio = Debt/ Total Assets

                    = 2250/ 4500

                    = 505

Solution 2

Taking a loan will increase the amount debt in the balance sheet. It will also increase total asset balance as a new fixed asset is being purchased. Therefore, Both total asset and debt will increase by the same amount. This transaction will increase both numerator and denominator by the same amount in debt ratio formula, therefore, debt ratio will increase.

Solution 3

If the company leases the asset and does not capitalize it will reduce both debt and asset by the same amount. Since this transaction will decrease both numerator and denominator by the same amount in debt ratio formula, therefore, debt ratio will decrease.

Solution 4

If the company leases the asset and does not capitalize it will reduce both debt and asset by the same amount. Debt ratio is a measure of financial risk. Reduction in debt ratio will decrease the financial risk of the firm.

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