Question 1: Which of the following statements is most correct?
A. Firms which use "off balance sheet" financing, such as leasing, will show lower debt ratios once the effects of their leases are reflected in their financial statements.
B. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation.
C. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan.
D. Capital, or financial, leases generally provide for maintenance service on the part of the lessor and can be refinanced at the discretion of the lessee.
E. A key difference between a capital lease and an operating lease is that with a capital lease, the total lease payments on the asset are roughly equal to the full price of the asset plus a return on the investment in the asset.
Question 2: Bombay Company's balance sheet is as follows: (NWC = net working capital; LTA = long term assets; D = debt; S= equity; V = firm value):
Book Values Market Values
NWC 200 D 500 NWC 200 D 500
LTA 2300 S 2000 LTA 2800 S 2500
V 2500 V 2500 V 3000 V 3000
According to MM's Proposition I corrected for taxes, what will be the change in company value if Bombay issues $200 of equity and uses it to make a permanent reduction in the company's debt? Assume a 35% tax rate.