An all-equity new firm is developing its business plan. It will require $615,000 of assets (which equals common equity), and it projects $450,000 of sales and $355,000 of operating costs for the first year. Management is reasonably sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires it to have a TIE of at least 4.0The firm will use debt and common equity for financing. What is the maximum debt to capital ratio (measured as debt/total common equity) the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt to capital ratio.)
A) 44.15%
B) 46.47%
C) 48.92%
D) 51.49%

Question

Quizplus · Accepted Answer

Step 1:
Calculate the EBIT:
EBIT = Sales - Operating Costs = $450,000 - $355,000 = $95,000

Step 2:
Calculate the maximum interest the firm can pay:
Interest = EBIT/TIE = $95,000/4 = $23,750

Step 3:
Calculate the maximum amount of debt the firm can have:
Max Debt = Interest/Interest Rate = $23,750/0.075 = $316,667

Step 4:
Calculate the maximum debt to capital ratio:
Max Debt to Capital = Max Debt/Total Assets = $316,667/($316,667 + $615,000) = 51.49%

Therefore, the maximum debt to capital ratio the firm can use is 51.49%. The best choice is D.

An All-Equity New Firm Is Developing Its Business Plan