A firm is analyzing two possible capital structures-30 and 50 percent debt ratios. The firm has total assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of40 percent on ordinary income. If the interest rate on debt is 7 percent and 9 percent for the 30 percent and the 50 percent debt ratios, respectively, the amount of interest on the debt under each of the capital structures being considered would be
A) 30 percent debt ratio: $135,000 and 50 percent debt ratio: $175,000.
B) 30 percent debt ratio: $245,000 and 50 percent debt ratio: $225,000.
C) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $250,000.
D) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $225,000.

Question

Quizplus · Accepted Answer

First, we need to find out the amount of debt under each capital structure:

30% debt ratio: Total Assets * Debt Ratio = $5,000,000 * 0.30 = $1,500,000

50% debt ratio: Total Assets * Debt Ratio = $5,000,000 * 0.50 = $2,500,000

Next, we can calculate the interest on the debt for each capital structure:

30% debt ratio: $1,500,000 * 0.07 = $105,000

50% debt ratio: $2,500,000 * 0.09 = $225,000

Therefore, the best choice is D, as it correctly identifies the interest on the debt under each capital structure.

A Firm Is Analyzing Two Possible Capital Structures-30 and 50