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Name: Problem Set 5 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 a. b. c. d. 300 500 800 Debt Equity Total claims 400 400 800 What is Reynolds's current debt ratio? What would the company's debt ratio be if it purchased the equipment? What would the company's debt ratio be if the equipment were leased? Would the company's financial risk be different under the leasing and purchasing alternatives? 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, 0.1481, and 0.0741.) Solutions to Module 5 Practice Problems Practice Problem 1 - Effects of leasing of financial statements Two companies, Energy Inc. and Hastings Corporation, began operations with identical balance sheets. A year later, both required additional fixed assets at a cost of $50,000. Energy Inc. obtained a 5-year, $50,000 loan at an 8% interest rate from its bank. Hastings, on the other hand, decided to lease the required $50,000 capacity for 5 years, and an 8% return was built into the lease. The balance sheet for each company, before the asset increases, shows the following: Current assets Fixed assets Total assets 25,000 125,000 150,000 Debt Equity Total claims 50,000 100,000 150,000 a. Show the balance sheets for both firms after the asset increase and calculate each firm's new debt ratio. (Assume that the lease is not capitalized.) b. Show how Hastings' balance sheet would look immediately after the financing if it capitalized the lease. Solution a. Balance sheets before lease is capitalized Energy Inc. Balance Sheet (Owns new assets) (Thousands of Dollars) Current assets $ 25,000 Debt $100,000 Fixed assets 175,000 Equity 100,000 Total assets $200,000 Total claims $200,000 Debt/assets ratio = $100/$200 = 50%. Current assets Hastings Corporation Balance Sheet (Leases as operating lease) (Thousands of Dollars) $ 25,000 Debt $ 50,000 Fixed assets 125,000 Total assets $150,000 Equity Total claims Debt/assets ratio = $50/$150 = 33%. Page 1 of 3 100,000 $150,000 Solutions to Module 5 Practice Problems b. Balance sheet after lease is capitalized Hastings Corporation Balance Sheet (Capitalizes lease) (Thousands of Dollars) Current assets $ 25,000 Debt Value of leased asset 50,000 Fixed assets 125,000 Equity 100,000 Total assets $200,000 Total claims $200,000 PV of lease payments $ 50,000 50,000 Debt/assets ratio = $100/$200 = 50%. Practice Problem 2 - Lease analysis 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 were leased, the lease would not have to be capitalized. Assume that Reynolds'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? Solution Cost of owning: Year 0 Cost -200 Depreciation tax shield Net cash flows -200 PV at 6% = -$127 Cost of leasing: After-tax lease payments: At the end of Year 0: -66 At the end of Year 1: -66 PV at 6% = -$128. NAL = $128 - ($127) = $1. 1 40 40 2 40 40 Reynolds should buy the equipment, because the cost of owning is less than the cost of leasing. Page 2 of 3 Solutions to Module 5 Practice Problems Practice Problem 3 - Lease analysis Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply: The machinery falls into the MACRS 3-year class. Under either the lease or the purchase, Big Sky must pay for insurance, property tax and maintenance. The firm tax rate is 40%. The loan would have an interest rate of 15%. The lease terms call for $400,000 payments at the end of the next 4 years. Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $250,000 at the end of 4th year. What is the NAL of the lease? Solution After-tax cost of debt = 15% (1 - tax rate) = 15% 0.6 = 9% Cost of Owning: 0 1 2 3 After-tax loan ($135,000) ($135,000) ($135,000) payments Depr. tax savings $199,980 $266,700 $88,860 Residual value Tax on residual Net cash flow $0 $4,980 $131,700 ($46,140) PV of owning at 9% = $885,679.47 Cost of Leasing: 0 1 2 Lease payment (240,000) (240,000) (AT) Net cash flow $0 (240,000) (240,000) 4 ($1,635,000) $44,460 $250,000 ($100,000) ($1,440,540) 3 (240,000) 4 (240,000) (240,000) (240,000) PV of leasing at 9% = $777,532.77 NAL = PV of leasing - PV of owning = $777,532.77 - ($885,679.47) = $108,146.70 Since the cost of leasing the machinery is less than the cost of owning it, Big Sky Mining should lease the equipment. Page 3 of 3