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. Reynold’s balance sheet prior to the acquisition of the equipment is as follows:
Current assests $300 Debt $400
Net fixed assests 500 Equity 400
Total assets $800 Total claims $800
a. (1) What is Reynold’s current debt ratio?
(2) What would be the company’s debt ratio if it purchased the equipment?
(3) What would be the debt ratio if the equipment were leased?
b. Would the company’s financial risk be different under the leasing and purchasing alternatives?
2.3 Consider the data in problem 2.2. Assume that Reynold’s tax rate is 40% and that the equipment’s depreciation would be $100 per year. If the company leased the asset on a 2-year lease, the payment would be $110 at the beginning of each year. If Reynolds borrowed and bought, the bank would charge 10% interest on the loan. In either case, the equipment is worth nothing after 2 years and will be discarded. Should Reynolds lease or buy the equipment?