Case 9-2 Purchase of Assets

On October 10, 2005, Mason Engineering Company completed negotiations
on a contract for the purchase of new equipment. Under the terms of the
agreement, the equipment may be purchased now or Mason may wait until
January 10, 2006, to make the purchase. The cost of the equipment is
$400,000. It will be financed by a note bearing interest at the market rate of
interest. Straight-line depreciation over a ten-year life will be used for book
purposes. A double-declining balance over seven years will be used for tax
purposes. (One-half year’s depreciation will be taken in the year of purchase
regardless of the date of purchase.)

Required:
a. Discuss the financial statement impacts of postponing the purchase of
the equipment. Would the market price of the firm’s common stock be
affected by any or all of these impacts? Do not assume in your discussion
that the postponement will affect revenues or any operating costs,
other than depreciation.

b. Discuss any cash flow impacts related to postponing the purchase of
the equipment.

c. Efficient markets assume that stockholder wealth is affected by the
amount and timing of cash flows. Which alternative is more favorable
to them: purchasing before year-end or waiting until January? Explain
your answer.

a. The financial statement impacts of postponing the purchase of the equipment will primarily affect the balance sheet and the income statement.

On the balance sheet, if the purchase is postponed until January, the equipment cost of $400,000 will not be recorded as an asset on the company's books until then. This means that the company's total assets will be lower, resulting in a decrease in both total assets and total equity. This decrease in equity could potentially have an impact on the market price of the company's common stock, as it might signal to investors that the company is not making necessary investments in its infrastructure.

On the income statement, the postponement of the purchase will result in lower depreciation expense for the current year. Straight-line depreciation over a ten-year life would result in an annual depreciation expense of $40,000 ($400,000 divided by 10 years), while double-declining-balance depreciation over seven years would result in a higher annual depreciation expense. However, since only half a year's depreciation is taken in the year of purchase, the impact on the current year's income statement would be the same regardless of the depreciation method used. Therefore, the postponement of the purchase would not have any direct impact on the company's net income for the current year.

b. The cash flow impacts related to postponing the purchase of the equipment would mainly involve the timing of cash flows. If the company decides to postpone the purchase until January, it would have an immediate positive impact on the company's cash flow for the current year. The $400,000 cost of the equipment would not be paid until January, which means the cash outflow would be delayed. This delay in cash outflow would improve the company's cash position in the short term, allowing for potential investment in other areas or the ability to meet other financial obligations.

c. From the perspective of stockholders, the alternative that is more favorable to them depends on their ability to assess the impact of the timing of cash flows on stockholder wealth.

If stockholders consider the time value of money and the impact of the delay in cash outflows, they would likely find that the alternative of waiting until January to purchase the equipment is more favorable. By postponing the purchase, the company can retain the $400,000 in cash for a few months, allowing for potential investment or interest earnings. Additionally, if the company's stockholders have a higher required rate of return than the market rate of interest on the note used to finance the equipment, then waiting until January could potentially result in a higher overall return for stockholders.

However, if stockholders prioritize the long-term growth prospects and the perception of the company's investment in its infrastructure, they might find that purchasing the equipment before year-end is more favorable. By making the purchase now, the company demonstrates its commitment to investing in its operations, which could positively impact investor confidence and potentially increase the market price of the firm's common stock.