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.

Question

Quizplus · Accepted Answer

Debt-to-equity ratio = Total Debt / Total Equity
Before prepayment: Total Debt = $16,000,000
Total Equity = $26,000,000

Debt-to-equity ratio = $16,000,000 / $26,000,000 = 0.62

After prepayment: Total Debt = $13,000,000 ($16,000,000 - $3,000,000)
Total Equity = $26,000,000

Debt-to-equity ratio = $13,000,000 / $26,000,000 = 0.50

Therefore, prepaying the bonds would cause the firm's debt-to-equity ratio to improve from 0.62 to 0.50. Choice A is the correct answer.

Saffron Industries Most Recent Balance Sheet Reports Total Assets of $42,000,000,total