1. A new firm is developing its business plan. It will require $565,000 of assets, and it projects $452,800 of sales and $354,300 of operating costs for the first year. Management is quite 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 4.0, and if the TIE falls below this level the bank will call in the loan and the firm will go bankrupt. What is the maximum debt ratio the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt ratio.)
2. Stewart Inc.'s latest EPS was $3.50, its book value per share was $22.75, it had 215,000 shares outstanding, and its debt ratio was 46%. How much debt was outstanding?
Cash $14,000 Accounts Payable $42,000
Receivables 70,000 Other current 28,000
Inventories 210,000 Total CL 70,000
Total CA 294,000 Long -term debt 70,000
Net fixed assets 126,000 Common equity 280,000
total assets 420,000 Total liab. and equity $420,000
Net Income $21,000
The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.70, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change?
1. EBIT = Revenue - Expenses = 452,800-354,300 = 98,500
TIE = EBIT/Interest
For a TIE of 4, Interest = 98,500/4 = 24,625
Given that interest rate is 7.5%
Amount of debt = 24,625/7.5% = 328,333
Debt ratio = debt/assets = 328,333/565,000 = 58.11%
2. Book value per ...
The solution explains some multiple choice questions relating to debt ratio, debt outstanding and ROE