Two textile companies, McDaniel-Edwards Manufacturing and Jordan-Hocking Mills, began operations with identical balance sheets. A year later both required additional manufacturing capacity at a cost of $200,000. McDaniel-Edwards obtained a 5-year, $200,000 loan at an 8% interest rate from its bank.
Jordan-Hocking, on the other hand, decided to lease the required $200,000 capacity from National Leasing for 5 years; an 8% return was built into the lease. The balance sheet for each company, before the asset increases, is as follows:
Debt…………………………………………$200,000
Equity………………………………………...200,000
Total assets………………………………….$400,000
Total liabilities and equity………………….$400,000
a. Show the balance sheet of each firm after the asset increase and calculate each firm’s new debt ratio. (Assume that Jordan-Hocking’s lease is kept off the balance sheet.)
b. Show how Jordan-Hocking’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?