Question

A new firm is developing its business plan. It will require $735,000 of assets (which equals total invested capital), and it projects $450,000 of sales and $355,000 of operating costs for the first year. Management is reasonably sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires it to have a TIE of at least 4.0, and if the TIE falls below this level the bank will call in the loan and the firm will go bankrupt. The firm will use only debt and common equity for financing. What is the maximum debt to capital ratio (measured as debt/total invested capital) the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt to capital ratio.) Do not round your intermediate calculations.

Answer 1

The maximum debt to capital ratio is 43.08%

Step-by-step explanation:

Since in the question, the Times interest earned ratio is given through which we can compute the amount of interest expense. But before that, we have to find out the Earning before income and taxes (EBIT) amount.

So, the EBIT = Sales - operating cost

= $450,000 - $355,000

= $95,000

And, the times interest earned ratio = EBIT ÷ Interest expense

4 times = $95,000 ÷ Interest expense

So, the interest expense = $23,750

The interest rate is given 7.5% but we have to use this rate so that the value of debt can be calculated.

Let us assume the debt value is 100

So, the debt value = Interest expense × (Assume debt ÷ interest rate)

= $23,750 × (100 ÷ 7.5%)

= $316,667

And, the total asset is $735,000

So, the debt to capital ratio equals to

= (Debt ÷ total invested capital) × 100

= $316,667 ÷ $735,000

= 43.08%