The balance sheet as of December 31, 1996, for Thompkins Laundry follows. Assets Liabilities and Stockholders’ Equity Current assets $10,000 Current liabilities $10,000 Noncurrent assets 60,000 Long-term liabilities Stockholders’ equity Total liabilities and 20,000 40,000 Total assets $70,000 stockholders’ equity $70,000 The $20,000 of long-term debt on the balance sheet represents a long-term note that requires Thompkins to maintain a debt/equity ratio of less than 1:1. If the covenant is violated, the company will be required to pay the entire principal of the note immediately. On January 1, 1997, Thompkins entered into a lease agreement. The agreement provides the company with laundry equipment for five years, for an annual rental fee of $5,000. REQUIRED:

a. Compute Thompkins’ debt/equity ratio as of January 1, 1997, if the company treats the lease as an operating lease.

b. Compute Thompkins’ debt/equity ratio as of January 1, 1997, if the company treats the lease as a capital lease. Assume an effective interest rate of 12 percent.

c. Compare the expenses recognized during 1997 if the lease is treated as operating to the expenses recognized during 1997 if the lease is treated as capital. Assume that the leased equipment has a five-year useful life and is depreciated using the straight-line method.

d. Discuss some of the reasons why Thompkins would want to treat the lease as an operating lease. How might the company arrange the terms of the lease so that it will be considered an operating lease?