Name: Rudy Alvarez

Problem Set 5
Due on or before Day 6 (Monday)
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

300
500
800

Debt
Equity
Total claims

400
400
800

a. What is Reynoldss current debt ratio?

$400/$800= 50%
b. What would the companys debt ratio be if it purchased the equipment?
Current assets
$300
Fixed assets
$500
Leased equipment $200
Total assets
$1000
Debt including lease
Equity
Total claims

$600
$400
$1,000

Debt ratio after purchasing equipment: $600/$1000= 60%

c. What would the companys debt ratio be if the equipment were leased?
$400/$800=50%
d. Would the companys financial risk be different under the leasing and purchasing alternatives?
The financial risk would be no different under a lease or a purchase if the interest rate on the lease is
equivalent to the loan.
Other financial risk considerations include whether the lease is an operating lease or a financial
lease. If it is an operating lease, it usually means that maintenance is included and cancelable. If
there are high costs to the repairs of the equipment and the equipment is only needed over the short
term there may be an incentive to pursue this route versus a purchase which would mean that the
company is now responsible for the maintenance and service of that equipment. Especially if those
maintenance and service costs are especially high those are considerations that the company should
take into account after determining the break-even point and time frame analysis.

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, 0.15, and 0.07.)
Cost

MACRS rates

Depreciation per year

0.3333

$13,332 (year 1)

0.4445

$17,780 (year 2)

0.15

$6,000 (year 3)

0.07

$2,800 (year 4)

$40,00
0
$40,00
0
$40,00
0
$40,00
0

Purchasing
Tax benefit on

Maintenance

Present value

YEAR

Installment

Depreciation

depreciation

contract/yr

Cash flow

factor at 10%

PV of Cash flow

$12,174

$13,332

$5,333

$1,000

$7,841

0.91

$7,128

$12,174

$17,780

$7,112

$1,000

$6,062

0.83

$5,010

$12,174

$6,000

$2,400

$1,000

$10,774

0.75

$8,095

$12,174

$2,800

$1,120

$1,000

$12,054

0.68

$8,233

(10,000)

0.68

(6,830)

salvage value,
year 4
PV Total cash
flows

$21,636

Leasing
Present
Tax

value

Present

Lease

benefit on

Cash

factor at

value of

YEAR

payment

lease

flow

10%

cash flow

$10,000

$4,000

$6,000

0.91

$5,455

$10,000

$4,000

$ 6,000

0.83

$4,959

$10,000

$4,000

$6,000

0.75

$4,508

$10,000

$4,000

$6,000

0.68

$4,098

PV Total cash flows

$19,020

The present value cash flow for purchasing the truck is $21,636 and for leasing is $19,020.
The net advantage to leasing is $2,616