Question

The Karson Transport Company currently has net operating income of $503,000 and pays interest expense of $204,000. The company plans to borrow $1.01 million on which the firm will pay 9 percent interest. The borrowed money will be used to finance an investment that is expected to increase the​ firm's net operating income by $394,000 a year.

a) What is​ Karson's times interest earned ratio before the loan is taken out and the investment is​ made? The times interest earned ratio is times. ​(Round to two decimal​ places.)
Part 2 b.What effect will the loan and the investment have on the​ firm's times interest earned​ ratio? The new times interest earned ratio is__.

Answer 1

Karson's times interest earned ratio before the loan is approximately 2.47. After taking the loan and making the investment, the new times interest earned ratio would increase to approximately 3.04.

Step-by-step explanation:

To determine Karson's times interest earned ratio before taking out the loan, we use the following formula:

Times Interest Earned Ratio = Net Operating Income / Interest Expense

Before the loan and investment:

Net Operating Income = $503,000

Interest Expense = $204,000

Times Interest Earned Ratio = $503,000 / $204,000 ≈ 2.47

Now, if Karson takes out a loan of $1.01 million at 9% interest, the additional annual interest expense will be:

Additional Interest Expense = Loan Amount * Interest Rate

Additional Interest Expense = $1,010,000 * 0.09 = $90,900

The new total interest expense will be $204,000 (current interest expense) + $90,900 (additional interest) = $294,900.

After the investment:

New Net Operating Income = Original Net Operating Income + Increase from Investment

New Net Operating Income = $503,000 + $394,000 = $897,000

The new times interest earned ratio will then be:

New Times Interest Earned Ratio = New Net Operating Income / New Total Interest Expense

New Times Interest Earned Ratio = $897,000 / $294,900 ≈ 3.04