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
To answer the questions, let's analyze the financial statement impacts and cash flow impacts of postponing the purchase of the equipment for Mason Engineering Company.
1. Financial statement impacts:
By postponing the purchase of the equipment, the following financial statement impacts would occur:
- Income Statement: The depreciation expense for the equipment will not be recorded for the current year if the purchase is postponed until January 10, 2011. This will result in lower depreciation expense and, consequently, higher net income for the year.
- Balance Sheet: The equipment cost of $400,000 will not be included in the asset section of the balance sheet until the equipment is purchased. This will result in lower total assets and shareholders' equity.
- Cash Flow Statement: Since the equipment is not purchased, there will be no cash outflow for the equipment cost in the investing section of the cash flow statement. This will result in higher cash flow from operations and higher cash and cash equivalents.
Regarding the impact on the market price of the firm's common stock, the postponement of equipment purchase alone is unlikely to directly affect the stock price. The market price of the firm's common stock is primarily influenced by factors such as earnings, growth prospects, industry trends, and market conditions. However, if the decision to postpone the purchase is perceived by investors as a negative sign or indicative of management's uncertainty, it may indirectly affect the stock price.
2. Cash flow impacts:
Postponing the purchase of the equipment will have the following cash flow impacts:
- Cash Outflow: If the purchase is postponed until January 10, 2011, the cash outflow of $400,000 will occur in the following year. This will result in lower cash flow from investing activities in the current year.
- Cash Inflow: By postponing the purchase, the company will have higher cash flow from operations in the current year, as there will be no cash outflow for the equipment cost.
3. From an efficient market perspective, stockholder wealth is affected by the amount and timing of cash flows. To determine which alternative is more favorable to stockholders, we need to consider the time value of money and the opportunity cost of funds.
- Purchasing before year-end: If the company purchases the equipment before year-end, it will incur the equipment cost, resulting in an immediate cash outflow. However, it will also start depreciating the equipment, which will provide tax benefits (depreciation expense reduces taxable income). The earlier purchase will result in lower cash flow from operations but will allow the company to start benefiting from depreciation for tax purposes earlier.
- Waiting until January: If the company waits until January to purchase the equipment, there will be no cash outflow in the current year. However, the company will delay the tax benefits associated with depreciation by a year and will have higher cash flow from operations in the current year.
The more favorable alternative depends on various factors, such as the company's tax situation, cash position, and opportunity cost of funds. Generally, deferring the purchase until January may be more favorable if the company has immediate cash flow needs or if it can invest the funds in higher-returning opportunities before the equipment purchase. On the other hand, purchasing before year-end may be more favorable if the company wants to start taking advantage of tax benefits sooner or if it expects the equipment's early use to generate increased revenue or cost savings.
Please note that this analysis is based on the given information and may be subject to additional considerations or assumptions that could alter the conclusion.