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? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt to capital ratio.)

Answer 1

51.49%

Step-by-step explanation:

An all equity new firm is developing its business plan

It will require assets of $615,000

The firm projects $450,000 of sales and $355,000 of operating costs for the first year

The first step is to calculate the EBIT

EBIT= sales - operating costs

= $450,000-$355,000

= $95,000

The interest can be calculated as follows

Interest= EBIT/TIE

= 95,000/4

= $23,750

Since the bank can borrow loan at the rate of 7.5% them the debt is

= 23,750/7.5/100

= 23,750/0.075

= $316,666.7

Therefore the maximum debt to capital ratio can be calculated as follows

= 316,666.7/615,000 × 100

= 0.5149 × 100

= 51.49%

Hence the maximum debt to capital ratio is 51.49%