Question

Zoey was asked by the company controller to determine if the company could borrow more money for an expansion project. When she calculated a leverage ratio, she determined that the company already had 1.5 times as much debt as equity.

Do you agree with her assessment that the company should back off with borrowing more funds at this time?

a. Yes, but if the company would increase sales, it could go ahead with borrowing more funds.
b. Not necessarily. She should investigate the debt to equity ratios of other firms in the same industry.
c. Yes, but the firm should pursue equity investment until the ratio equals 1:1.
d. Not necessarily. In poor economic times, it is good financial strategy for a firm to be highly leveraged.

Answer 1

The decision on whether the company should borrow more funds with a debt-to-equity ratio of 1.5:1 depends on the industry standards and the company's capacity to service debt. Zoey should compare with other firms in the same industry to assess the appropriateness of further borrowing.

Step-by-step explanation:

In evaluating whether the company should borrow more funds for an expansion with a debt-to-equity ratio of 1.5:1, it is not necessarily wise to back off borrowing more funds. Zoey should consider the industry standards for leverage ratios. The correct answer to the question is therefore (b) Not necessarily. She should investigate the debt to equity ratios of other firms in the same industry. Industry norms can vary significantly, and what is considered high leverage in one industry may be standard in another. Moreover, the ability to service debt is also crucial, which depends on the company's cash flow and the cost of borrowing.

As for the viewpoint of a small firm contemplating how to raise capital for expansion, the decision to borrow or issue equity involves trade-offs. Borrowing can be more cost-effective if the firm believes it can service the debt and prefers not to dilute ownership. Issuing stock can be preferable if preserving cash flow is more critical and if the owners are willing to accept diluted ownership in exchange for less financial risk.

Answer 2

A) Yes, but if the company would increase sales, it could go ahead with borrowing more funds.

Step-by-step explanation:

There is no such thing as a good (low) or bad (too high) debt to equity ratio, it varies a lot depending on the industry and expected sales growth. E.g. when Goldman Sachs financed the initial expansion of FB ($10 billion), FB´s equity value was not even close to that value.

Usually financial agents consider a good equity ratio to be around 1 to 1.5, but financial agents themselves may have higher ratios than that.

If the new loan will help the company increase its sales, then it will eventually increase net profits which increase equity.