Digitrex Company had developed and successfully tested a computer system that the company believed had significant advantages over other computers in its price range. Digitrex was considering marketing the computer under any of three financial arrangements, at the customer’s option: (1) outright sale at $30,000, (2) a capital lease at $7,200 per year for five years, (3) an operating lease at $7,500 per year.

Before making a final decision on the terms for each option, John Ames, financial vice president, decided to estimate the options’ relative attractiveness to typical potential customers. For this purpose he devised a hypothetical company, Gamma Company, with financial statements as summarized in Exhibit 1. He assumed that except for the acquisition of a Digitrex computer, the income statements would continue unchanged for the next five years.

John recognized that a company would presumably perform a net present value analysis as part of its evaluation of the alternatives. However, he knew that the impact of the alternative on the financial statements was also a relevant consideration in most decisions, as, for example, a company might have a loan covenant that required a minimum level of working capital or current ratio. Therefore, John asked an assistant to calculate the effect of each of the three proposed financing methods on Gamma’s balance sheets and income statements, using the following assumptions:

1. The computer would be acquired on July 1, 2002 (i.e., in the middle of the year).
2. Gamma Company’s effective income tax rate was 40 percent. For simplicity, it was assumed that income taxes were paid in cash in the year to which the income tax expense was applicable. There was no investment tax credit in effect as of 2002.
3. If Gamma purchased the computer, it would depreciate the $30,00 cost using the income tax codes’ ACRS allowances over six calendar years (i.e., 2002-2007), both for income tax purposes and for its financial statements (see Exhibit 2). It would pay the $30,000 in cash on July 1, 2002. (Mr. Ames decided not to complicate the calculations by including the possibility that Gamma would borrow part of the purchase price).
4. If Gamma leased the computer on a capital lease, it would make five annual payments, each of $7,200, with the first on July 1, 2002. These payments were assumed to be treated in the same way for both income tax purposes and financial reporting purposes.
5. For income tax and financial reporting purposes, the interest expense applicable to each of the six calendar years was as follows: 2002, $1,145; 2003, $2,044; 2004 $1,526; 2005, $956; 2006, $329; 2007, $0. . . .

Assignment

1. For each of the three alternatives, estimate Gamma Company’s balance sheet as of July 1, 2002 (immediately after the acquisition of the computer) and its income statement for the second half of 2002, for each of the years 2003 through 2006, and for the first half of 2007. Round all numbers to the nearest $100. (Note that Exhibit 1 numbers are expressed in thousands of dollars.)
2. Are either or both of these lease alternatives so unattractive, as compared with outright purchase, that it would be a waste of effort for Digitrex to attempt to lease the computers?