Question

An all-equity new firm is developing its business plan. It will require $615,000 of assets (which equals common equity), 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. The firm will use debt and common equity for financing. What is the maximum debt to capital ratio (measured as debt/total common equity) the firm can use

Answer 1

51.49%

Step-by-step explanation:

Calculation to determine the maximum debt to capital ratio (measured as debt/total common equity) the firm can use

First step is calculate the Interest Expense

Using this formula

Times Interest earned ratio = Earning Before Interest and Tax / Interest Expense

Let plug in the formula

4.0 = ( Sales - operating costs ) / Interest Expense

4.0 = ( $450,000 - $355,000 ) / Interest Expense

4.0 = $95,000 / Interest Expense

Interest Expense = $95,000 / 4.0

Interest Expense = $23,750

Second step is to calculate the Total Debt

Interest Expense = Total Debt * Interest on Debt

$23,750 = Total Debt *7.50%

Total Debt = $23,750 / 7.50%

Total Debt = $316,667

Now let determine the Debt ratio

Debt ratio = Total Debt / Total Assets

Debt ratio = $316,667 / 615,000

Debt ratio = 51.49%

Therefore the maximum debt to capital ratio (measured as debt/total common equity) the firm can use is 51.49%