Etobicoke Enterprises.had a debt-to-equity ratio of 0.60.They have total shareholders' equity of $5 million.They also have operating leases that require annual payments at the end of the next 5 years of $285,000.If the discount rate that applies to the leases were 6%, what would their debt-to-equity ratio be if the leases were capitalized?

Question

Quizplus · Accepted Answer

To capitalize the leases, we need to find the present value of the lease payments using the given discount rate of 6%:
PV of lease payments = $285,000 * [(1-1/(1+0.06)^5)/0.06] = $1,232,029.77
This additional amount should be added to the company's liabilities, as it represents the present value of lease-related obligations. 
Total liabilities = Total equity / Debt-to-equity ratio = $5 million / 0.60 = $8,333,333.33
Total liabilities with lease capitalized = $8,333,333.33 + $1,232,029.77 = $9,565,363.10
Debt-to-equity ratio with lease capitalized = Total liabilities / Total equity = $9,565,363.10 / $5 million = 1.91
So, the answer is C (0.84) because the debt-to-equity ratio increases from 0.60 to 0.84 when lease obligations are capitalized.