Problem Set 5
Uploaded by
Rudy AlvarezProblem Set 5
Uploaded by
Rudy AlvarezName: Rudy Alvarez
Problem Set 5
Due on or before Day 6 (Monday)
Assigned Problem 1
Reynolds Construction needs a piece of equipment that costs $200. Reynolds can either lease the equipment or
borrow $200 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
Fixed assets
Total assets
300
500
800
Debt
Equity
Total claims
400
400
800
a. What is Reynoldss current debt ratio?
$400/$800= 50%
b. What would the companys debt ratio be if it purchased the equipment?
Current assets
$300
Fixed assets
$500
Leased equipment $200
Total assets
$1000
Debt including lease
Equity
Total claims
$600
$400
$1,000
Debt ratio after purchasing equipment: $600/$1000= 60%
c. What would the companys debt ratio be if the equipment were leased?
$400/$800=50%
d. Would the companys financial risk be different under the leasing and purchasing alternatives?
The financial risk would be no different under a lease or a purchase if the interest rate on the lease is
equivalent to the loan.
Other financial risk considerations include whether the lease is an operating lease or a financial
lease. If it is an operating lease, it usually means that maintenance is included and cancelable. If
there are high costs to the repairs of the equipment and the equipment is only needed over the short
term there may be an incentive to pursue this route versus a purchase which would mean that the
company is now responsible for the maintenance and service of that equipment. Especially if those
maintenance and service costs are especially high those are considerations that the company should
take into account after determining the break-even point and time frame analysis.
Assigned Problem 2
Delmont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck with a 4-year
life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan
rate would be 10%, and the loan would be amortized over the truck's 4-year life, so the interest expense for
taxes would decline over time. The loan payments would be made at the end of each year. The truck will be
used for 4 years, at the end of which time, it will be sold at an estimated residual value of $10,000. If DTC buys
the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year.
The lease terms, which include maintenance, call for a $10,000 lease payment at the beginning of each year (i.e.
4 payments total). DTC's tax rate is 40%.
What is the net advantage to leasing?
(Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07.)
Cost
MACRS rates
Depreciation per year
0.3333
$13,332 (year 1)
0.4445
$17,780 (year 2)
0.15
$6,000 (year 3)
0.07
$2,800 (year 4)
$40,00
0
$40,00
0
$40,00
0
$40,00
0
Purchasing
Tax benefit on
Maintenance
Present value
YEAR
Installment
Depreciation
depreciation
contract/yr
Cash flow
factor at 10%
PV of Cash flow
$12,174
$13,332
$5,333
$1,000
$7,841
0.91
$7,128
$12,174
$17,780
$7,112
$1,000
$6,062
0.83
$5,010
$12,174
$6,000
$2,400
$1,000
$10,774
0.75
$8,095
$12,174
$2,800
$1,120
$1,000
$12,054
0.68
$8,233
(10,000)
0.68
(6,830)
salvage value,
year 4
PV Total cash
flows
$21,636
Leasing
Present
Tax
value
Present
Lease
benefit on
Cash
factor at
value of
YEAR
payment
lease
flow
10%
cash flow
$10,000
$4,000
$6,000
0.91
$5,455
$10,000
$4,000
$ 6,000
0.83
$4,959
$10,000
$4,000
$6,000
0.75
$4,508
$10,000
$4,000
$6,000
0.68
$4,098
PV Total cash flows
$19,020
The present value cash flow for purchasing the truck is $21,636 and for leasing is $19,020.
The net advantage to leasing is $2,616