ABC Company

Balance Sheet

Actual December 31, 2019 (in $000s)

Assets Liabilities & Shareholders Equity

Cash $ 40,000 Accounts payable (days 35) $ 9,200

Accounts receivable (days 90) 46,850 Long-term debt 30,800

Inventory (days 50) 13,150

Buildings and equipment 150,000

Accumulated amortization

Buildings and equipment (50,000) Common shares 100,000

Retained earnings 60,000

$200,000 $200,000

ABC Company

Forecasted Balance Sheet

December 31, 2020 (in $000s)

Assets Liabilities & Shareholders Equity

Cash $ 9,300 Accounts payable (days 47) $ 13,000

Accounts receivable (days 95) 52,000 Long-term debt 42,000

Inventory (days 50) 13,700

Buildings and equipment 205,000

Accumulated amortization

Buildings and equipment (55,000) Common shares 100,000

Retained earnings 70,000

$225,000 $225,000

During 2020, ABC Company (ABC) is expected to have a net income of $20,000,000 and has a 50% dividend payout ratio. The company desires to have a minimum cash level of $10,000,000. This goal was 5% of its 2019 total assets. Cash has not been adjusted in the forecast for 2020. Depreciation and amortization of $5,000,000, new equipment purchases of $55,000,000 and interest expense of $2,000,000 was included in the 2020 forecast. The condensed income statements for forecasted 2020 and actual 2019 are as follows (in $000s):

2020 2019

` Sales $200,000 $190,000

Cost of sales (variable COGS) ( 80,000) ( 76,000)

Fixed costs in COGS (incl. Dep) ( 20,000) ( 20,000)

Other Fixed costs (incl. Interest) ( 60,000) ( 60,000)

Taxes ( 20,000) ( 16,000)

Net income $ 20,000 $ 18,000

XYZ Company (XYZ) is considering buying ABC Company for $180,000,000 to $200,000,000 at the beginning of 2020. XYZ financing of the purchase is outside the scope of this case. Also, the price of the company should not be more than 4 times Earnings before Interest Taxes, Depreciation and Amortization (EBITDA).

The CFO of XYZ will only recommend buying if ABC has positive operating cash flows, maintains a current ratio of minimum 1:1, has a maximum interest bearing debt to equity ratio of 0.3:1, has reasonable cash levels and other key operating ratios are trending positively. XYZ requires a 10% WACC in accepting investments and at least a 13.33% return for equity holders. The XYZ CFO thinks, as well, that maintaining a cash level of 45 days fixed costs could be prudent for ABC Company and/or a line of credit should be pursued.

The ABC Company CFO is considering leasing equipment rather than purchasing new equipment. The equipment budget for 2020 is $55,000,000. The company uses a 10% weighted average cost of capital. The current long-term debt financing interest rate is 5% and the company tax rate is 50%. The equipment is depreciated over 10 years for accounting purposes while the tax rules allow the equipment to be depreciated equally over two years. The present value of the tax depreciation benefit is $23,865,000. A lessor has agreed to provide a lease for the equipment to the company for $5,800,000 per year before taxes for 10 years (assume a tax rate of 50%). There is $5,000,000 of residual value at the end of the lease. The lease debt would be booked as a long-term obligation along with a long-term asset.

Required:

1. Prepare an analysis of whether a lease is advantageous compared to a purchase and financing of the $55,000,000 of equipment. (10 marks)
2. What are two (2) potential benefits to consider in the leasing decision and, if the lease debt was the best option, is there a covenant issue to be negotiated? (4 marks)
3. Describe the advantage to the company regarding the difference in the depreciation timing under accounting rules versus tax rules for a $55,000,000 purchase. (3 marks)
4. How does the concept of match term funding apply in the decision process of the CFO? How does it compare to the forecasted financing strategy for 2020? (3 marks)