Problem 19-1 Balance Sheet Effects Reynolds Construction needs a piece of equipm
ID: 2730326 • Letter: P
Question
Problem 19-1 Balance Sheet Effects Reynolds Construction needs a piece of equipment that costs $150. Reynolds either can lease the equipment or borrow $150 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 assets $350 Debt $450 Net Fixed assets 450 Equity 350 Total assets $800 Total claims $800 a. 1.What is Reynolds' current debt ratio? Round your answer to two decimal places. % 2.What would be the company's debt ratio if it purchased the equipment? Round your answer to one decimal place. % 3.What would be the debt ratio if the equipment were leased? Round your answer to two decimal places. % b.Would the company's financial risk be different under the leasing and purchasing alternatives? -Select-IIIIIIIV I. 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. II. 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. III. 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. IV. 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.Explanation / Answer
1) Current Debt ratio = Total Debt / Total assets
Total Debt = $ 450
Total assets = $ 800
Current debt ratio = 450 / 800
= 0.5625
Conclusion:- Current debt ratio = 0.5625
2) If Reynolds Construction purchase the equipment by borrowing from bank, then debt ratio will be calculated as follows:-
Total debt = 450 (Existing Borrowing) + 150 (Borrowing for Purchase of equipment)
= $ 600
Total asset = 800 (Existing total assets) + 150 (New equipment)
= $ 950
Revised debt ratio = 600 / 950
= 0.6316 (approx)
Conclusion:- The company's debt ratio will be 0.6316 if it purchase the equipment.
3) The debt ratio will be 0.5625 if the equipment were leased because this lease will be classified in the category of Operating lease and in case of operating lease, only lease payments are recorded as expense in Income Statement. An operating lease is not recorded on balance sheet.