Spot Inc. needs to acquire a machine that costs $750,000 and has an operating life of five years, at the end of which its scrap value would be 10 percent of the initial purchase price.

BRS Bank offers Spot Inc. the following alternative financing options for the specified machine:

•	Option 1: a five-year lease with an annual lease payment of $155,000, payable at the beginning of each year. The machine must be returned to BRS Bank at the end of five years.
•	Option 2: a five-year bank loan for $750,000 at an annual interest rate of 7 percent. If Spot Inc. takes the loan, it will be subject to certain bank covenants.

Forecasted Financial Information

The following forecasts assume that the bank loan is used to finance the acquisition of the machine.

Spot Inc.
Forecasted Statement of Financial Position for Year 1

Assets
Current assets
Cash and cash equivalents	$ 150,000
Accounts receivable, net	1,750,000
Inventory	2,250,000
Prepaid expenses and other assets	50,000
Total current assets	4,200,000
Non-current assets
Property, plant, and equipment, net	4,500,000
Goodwill	500,000
Total non-current assets	5,000,000
Total assets	$9,200,000
Liabilities
Current liabilities
Accounts payable	$1,500,000
Accrued expenses	100,000
Total current liabilities	1,600,000
Non-current liabilities
Bonds	1,750,000
Bank loan	750,000
Total non-current liabilities	2,500,000
Total liabilities	$4,100,000
Shareholders' equity
Common stock	$2,000,000
Additional paid-in capital	1,000,000
Retained earnings	2,100,000
Total shareholders' equity	5,100,000
Total liabilities and shareholders' equity	$9,200,000

Spot Inc.
Forecasted Statement of Operations for Year 1

Sales	$9,200,000
Operating expenses
Cost of goods sold	3,600,000
Cost of services	1,500,000
Compensation and benefits	1,200,000
Administrative expense	700,000
Depreciation expense	800,000
Total operating expenses	7,800,000
Income from operations	1,400,000
Interest expense	150,000
Net income	$1,250,000

Please note the following additional information:

Forecasted cash flow from operations for Year 1 = $1,100,000

Actual total equity for Year 0 = $4,900,000

BRS Bank (the "Lender") is prepared to enter into a loan agreement with Spot Inc. (the "Company") to provide financing for the acquisition of a machine costing $750,000. The purpose of this letter is to disclose loan covenants pursuant to the loan agreement with BRS Bank.

Until the loan's principal and interest have been paid in full, the Company covenants and agrees with the Lender that:

1.1 The Company will not permit the quick ratio to be less than 1.10.
1.2 The Company will not permit the total debt ratio to exceed 0.60.
1.3 The Company will not permit the times interest earned ratio to be less than 10.00.
1.4 The Company will not permit the return on equity to be less than 0.20.
1.5 The Company will not permit the operating cash flow ratio to be less than 1.00.
1.6 The Company will not permit the profit margin to be less than 0.05.

PART I

Enter the present value of the net cash outflow of each option in column B, rounded to the nearest dollar. Net outflows should be entered as negative.

	A	B
1	Present Value of Net Cash Outflow:	Amount
2	Option 1
3	Option 2

PART II

Select the advantages of each option by selecting from the option list provided in column B. A selection may be used once, more than once, or not at all.

	A	B
1	Advantages of:	Advantages
2	Option 1
3
4	Option 2
5

PART III

Calculate the financial ratios for Spot Inc. based on Spot Inc.'s forecasted financial information. In column B, enter the required amounts. Round all ratios to two decimal places. The information in the Analytics Definitions exhibit must be used for all financial ratio calculations.

In column C, indicate whether each of the financial metrics will be in compliance with the bank loan covenants at the end of the first year by clicking in the associated cell and selecting "Yes" or "No" as appropriate.

	A	B	C
1	Ratio	Amount	In Compliance With Debt Covenants?
2	Quick ratio
3	Total debt ratio
4	Times interest earned
5	Return on equity
6	Operating cash flow ratio
7	Profit margin

PART IV

In column B, indicate whether the company should lease or buy the machine by selecting from the option list provided.

	A	B
1		Decision
2	Which option should Spot Inc. choose?

Answer rating: 100% (QA)

To solve the problem lets calculate the present value of the net cash outflow for each option determine the advantages of each option calculate the financial ratios and make a recommendation PART I To ... View the full answer