Hutchinson Corporation has zero debt⎯it is financed only with common equity.Its total assets are $410,000.The new CFO wants to employ enough debt to bring the debt/assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value.How much must the firm borrow to achieve the target debt ratio?
A) $155,800
B) $164,000
C) $172,200
D) $180,810
E) $189,851

Question

Quizplus · Accepted Answer

Since there is no debt, the current equity/assets ratio is 100%. The desired debt/assets ratio is 40%, so the new equity/assets ratio must be 60%. This means that the firm will have to issue debt to finance a portion of its assets, and use the proceeds from the borrowing to buy back common stock at its book value.

Let's use X to represent the amount the firm needs to borrow. The new equity will be the original equity minus the amount borrowed (X), and the new assets will be the old assets plus the amount borrowed (X).

New equity/assets ratio = (old equity - X) / (old assets + X) = 60%
Solving for X gives: 
X = 0.6(old assets) - old equity = 0.6($410,000) - $410,000 = $164,000

Therefore, the firm must borrow $164,000 to achieve the target debt ratio.

Hutchinson Corporation Has Zero Debt⎯it Is Financed Only with Common