Tart Company's most recent balance sheet reports total assets of $42,000,000, total liabilities of $16,000,000 and shareholders' 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

Prepaying $3,000,000 of outstanding bonds would reduce both the company's total liabilities and total assets by $3,000,000. This would change the total liabilities to $13,000,000 and total assets to $39,000,000, with shareholders' equity remaining at $26,000,000. The initial debt-to-equity ratio is $16,000,000 / $26,000,000 = 0.615 (approximately .62). After prepaying the debt, the new debt-to-equity ratio would be $13,000,000 / $26,000,000 = 0.5. Therefore, prepaying the debt improves the debt-to-equity ratio from .62 to .50.

Tart Company's Most Recent Balance Sheet Reports Total Assets of $42,000,000