On October 10, 2010, 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, 2011, 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. Straight-line depreciation over a 10-year life will be used for book purposes. A double-declining balance over seven years will be used for tax purposes. (One-half year of depreciation will be taken in the year of purchase regardless of the date of purchase.)
Required:
1. 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.
2. Discuss any cash flow impacts related to postponing the purchase of the equipment.
3. 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.
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To answer these questions, we need to analyze the financial statement impacts and cash flow impacts of postponing the purchase of the equipment. Let's break it down and tackle each question separately:
1. Financial statement impacts:
- Postponing the purchase of the equipment would affect the income statement and balance sheet. On the income statement, the depreciation expense would be lower if the purchase is postponed, resulting in higher net income.
- On the balance sheet, the equipment would not be recorded as an asset if the purchase is postponed, meaning no increase in total assets. However, the liabilities might still be impacted if the equipment is financed through a note, as there will be interest expense recorded on the income statement.
- The market price of the firm's common stock may be affected by these impacts. Higher net income due to lower depreciation expense may result in higher earnings per share (EPS), which could potentially positively impact the stock price. However, the decision to postpone the purchase may also raise concerns among investors about the company's growth prospects or capital expenditure plans, which could have a negative impact on the stock price.
2. Cash flow impacts:
- If the purchase is postponed, there would be no immediate cash outflow to acquire the equipment, positively impacting the cash flow in the current period. However, there would still be cash outflows in the form of potential interest payments on the note used for financing the equipment.
- It's important to consider the time value of money when evaluating the cash flow impacts. If the purchase is postponed, the company would have access to the cash for additional time, potentially enabling it to invest or generate returns on that cash. On the other hand, if the equipment is needed urgently or is expected to generate significant cash flows, it might be more beneficial to purchase it sooner rather than later.
3. Shareholder wealth and efficient markets:
- Efficient markets assume that stockholder wealth is affected by the amount and timing of cash flows. To determine which alternative is more favorable to stockholders, we need to analyze the timing and amount of cash flows associated with purchasing before year-end or waiting until January.
- If the purchase is made before year-end, there would be an immediate cash outflow for the equipment, potentially impacting the current cash flow. However, the benefits of owning the equipment, such as increased production, cost savings, or potential revenue generation, could start earlier.
- If the purchase is postponed until January, there would be no immediate cash outflow but potential interest payments. However, the benefits of owning the equipment might be delayed.
- Considering the time value of money and the potential benefits of owning the equipment earlier, purchasing before year-end might be more favorable to shareholders if the benefits outweigh the immediate cash outflow and potential interest payments.
In summary, the decision to postpone the purchase of the equipment would have financial statement impacts, potentially affecting net income and the balance sheet. It could also have cash flow impacts, considering the timing of cash outflows and potential interest payments. Determining the most favorable alternative for shareholders would depend on factors such as the benefits of owning the equipment earlier and the potential impact on current cash flows, taking into account the time value of money.