Narcissus Corporation Has Entered into a Debt Agreement That Restricts

Narcissus Corporation has entered into a debt agreement that restricts its debt-to-equity ratio to less than two-to-one.The corporation is planning to expand its facilities,creating a need for additional financing.The board of directors is considering leasing the additional facilities but is concerned that leasing may violate its existing debt agreement.A violation of the debt agreement would place the corporation in default.The potential lessor insists that the lease be structured in such a way that it can be accounted for as a capital lease by the lessor (the lessor is a dealer and wants to recognized the dealer's gross profit on the transaction immediately).In addition,the lessor requires that the residual value of the leased asset be guaranteed when it reverts to the lessor at the end of the lease term.Narcissus's board has asked you to analyze the following alternative:
Alternative 1--Narcissus would enter into a lease that qualifies as a capital lease (to Narcissus).If this alternative is selected,Narcissus's reported debt-to-owners'-equity ratio would be 1.9,and its ability to issue debt in the future would be seriously constrained.
Alternative 2--Narcissus would enter into a lease and pay a third party to guarantee the residual value of the leased property.The lease would be structured in such a way as to qualify as an operating lease to Narcissus and as a capital lease to the lessor.In this case,Narcissus's reported debt-to-equity ratio would be unaffected by the lease contract.
Required:
Explain the consequences of each of these alternatives,including any ethical considerations that might exist.

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