Two textile companies, Mc Nulty-Grunewald Manufacturing and Jackson-Kenny Mills, began operations with identical balance sheets.A year later both required additional manufacturing capacity at a cost of $150,000. Mc Nulty-Grunewald obtained a 5-year, $150,000 loan at a 9% interest rate from its bank. Jackson-Kenny, on the other hand, decided to lease the required $150,000 capacity from National Leasing for 5 years; a 9% return was built into the lease. The balance sheet for each company, before the asset increases, is as follows:

 

a. Show the balance sheet of each firm after the asset increase, and calculate each firm’s new debt ratio. (Assume that Jackson-Kenny’s lease is kept off the balance sheet.)

b. Show how Jackson-Kenny’s balance sheet would have looked immediately after the financing if it had capitalized the lease.

c. Would the rate of return (1) on assets and (2) on equity be affected by the choice of financing? If so, how?

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Debt Equity Total liabilities and equity $150,000 100,000 Total assets $250,000 $250,000