Pitt Corporation's most recent balance sheet reports total assets of $35,000,000 and total liabilities of $17,500,000. Management is considering issuing $5,000,000 of par value bonds (at par) with a maturity date of ten years and a contract rate of 7%. What effect, if any, would issuing the bonds have on the company's debt-to-equity ratio?
A) Issuing the bonds would cause the firm's debt-to-equity ratio to improve from 1.0 to 1.3.
B) Issuing the bonds would cause the firm's debt-to-equity ratio to worsen from 1.0 to 1.3.
C) Issuing the bonds would cause the firm's debt-to-equity ratio to remain unchanged.
D) Issuing the bonds would cause the firm's debt-to-equity ratio to improve from .5 to .8.
E) Issuing the bonds would cause the firm's debt-to-equity ratio to worsen from .5 to .8.

Question

Quizplus · Accepted Answer

The debt-to-equity ratio is calculated as total liabilities divided by total equity. Currently, Pitt Corporation's debt-to-equity ratio is 1.0 (17,500,000/17,500,000). If the company issues $5,000,000 of bonds, the total liabilities would increase to $22,500,000 (17,500,000 + 5,000,000). Since the total equity remains the same, the new debt-to-equity ratio would be 1.286 (22,500,000/17,500,000), which is higher than the current ratio of 1.0. Therefore, issuing the bonds would cause the company's debt-to-equity ratio to worsen from 1.0 to 1.286, and the correct answer is B.

Pitt Corporation's Most Recent Balance Sheet Reports Total Assets of $35,000,000