Question

Saffron Industries most recent balance sheet reports total assets of $42,000,000, total liabilities of $16,000,000 and stockholders' equity of $26,000,000. Management is considering using $3,000,000 of excess cash to prepay $3,000,000 of outstanding bonds. What effect, if any, would prepaying the bonds have on the company's debt-to-equity ratio?

A) Prepaying the debt would cause the firm's debt-to-equity ratio to improve from .62 to .50.
B) Prepaying the debt would cause the firm's debt-to-equity ratio to improve from .62 to .57.
C) Prepaying the debt would cause the firm's debt-to-equity ratio to worsen from .62 to .50.
D) Prepaying the debt would cause the firm's debt-to-equity ratio to worsen from .62 to .57.
E) Prepaying the debt would cause the firm's debt-to-equity ratio to remain unchanged.

Answer 1

Prepaying the bonds will improve Saffron Industries' debt-to-equity ratio from .62 to .50. Consequently, the correct option is (A), as it positively affects the company's financial leverage.

Step-by-step explanation:

If Saffron Industries pre-pays $3,000,000 of outstanding bonds using its excess cash, here's the impact on the company's debt-to-equity ratio:

• Initial total liabilities: $16,000,000
• Initial stockholders' equity: $26,000,000
• Initial debt-to-equity ratio: $16,000,000 / $26,000,000 = 0.6154 (or approximately .62).
• After prepaying the debt, new total liabilities: $16,000,000 - $3,000,000 = $13,000,000
• New stockholders' equity (since cash is an asset, equity remains the same): $26,000,000
• New debt-to-equity ratio: $13,000,000 / $26,000,000 = 0.5

Prepaying the debt will cause the firm's debt-to-equity ratio to improve from .62 to .50. Therefore, the mentioned correct option in final answer is (A).