AK, Inc. is considering issuing additional long-term debt to finance an expansion. The company currently has $20 million in 5% debt outstanding. Its earnings after-tax (EAT) are $3.0 million, and its marginal and average tax rate is 40 percent. The company is required by the debt holders to maintain its times interest earned ratio at 3.0 or greater. How much additional 10 percent debt can the company issue now and maintain its times interest earned ratio at 3.0? Assume for this calculation that earnings before interest and taxes remains at its present level.
A) $10 million
B) $ 6 million
C) $ 1 million
D) $5 million

Question

Quizplus · Accepted Answer

The company's current times interest earned ratio is 3.0, which means that its earnings before interest and taxes (EBIT) are three times its interest expense. If the company issues additional debt, its interest expense will increase, and its EBIT will remain the same. Therefore, the company's times interest earned ratio will decrease. To maintain its times interest earned ratio at 3.0, the company can issue additional debt up to the point where its interest expense is one-third of its EBIT. The company's current EBIT is $3.0 million / (1 - 0.40) = $5.0 million. Therefore, the company can issue additional debt up to $5.0 million / 0.10 = $50 million. However, the company already has $20 million in debt outstanding, so it can issue an additional $50 million - $20 million = $30 million in debt.

AK, Inc Is Considering Issuing Additional Long-Term Debt to Finance an an Expansion