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A start-up company is seeking your advice concerning its debt ratio and capital structure decisions. It will require $1,000,000 of total assets and anticipates sales during its first year of operation to be $760,000. The sum of its operating costs and cost of goods sold will be $625,000. The company can borrow funds at an interest rate of 7.5% however, because of its high-risk business plan, the lender will require the firm to maintain a TIE (times-interest-earned) ratio of at least 5.5x. What is the maximum debt ratio the firm can use so as to meet its TIE ratio of 5.5x?

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Keith Leannon
Keith LeannonLv2
28 Sep 2019

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A start-up company is seeking your advice concerning its debt ratio and capital structure decisions. It will require $1,000,000 of total assets and anticipates sales during its first year of operation to be $760,000. The sum of its operating costs and cost of goods sold will be $625,000. The company can borrow funds at an interest rate of 7.5% however, because of its high-risk business plan, the lender will require the firm to maintain a TIE (times-interest-earned) ratio of at least 5.5x. What is the maximum debt ratio the firm can use so as to meet its TIE ratio of 5.5x?

(assume account payable, accrual interest, and deferred taxes are all equal to zero).

Hint: To determine the annual interest paid, use the following: INT($) = Debt x i

(where i = interest rate in %). Also, EBIT = Sales

A start-up company is seeking your advice concerning its debt ratio and capital structure decisions. It will require $1,000,000 of total assets and anticipates sales during its first year of operation to be $760,000. The sum of its operating costs and cost of goods sold will be $625,000. The company can borrow funds at an interest rate of 7.5% however, because of its high-risk business plan, the lender will require the firm to maintain a TIE (times-interest-earned) ratio of at least 5.5x. What is the maximum debt ratio the firm can use so as to meet its TIE ratio of 5.5x? (Note that by the term debt ratio I imply Debt/Total Assets from the 13th edition of our text, which in the 14th edition is called the Liabilities-to-assets ratio and is defined as Total liabilities/Total assets. Or assume account payable, accrual interest, and deferred taxes are all equal to zero).

All one question, the first part i have the answer to but the second part i dont understand...

1)Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000, operating costs to be $265,000, assets (capital) to be $200,000, and its tax rate to be 35%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a contract with existing bondholders the TIE ratio would have to be maintained at or above 4.0. Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure? a. 3.71% b. 4.08% c. 4.48% d. 4.93% e. 5.18%

Then it goes on to say, which is the problem i really need help on conceptually...

2)Which of the following statements is CORRECT?

a. Even though Firm A's current ratio exceeds that of Firm B, Firm B's quick ratio might exceed that of A. However, if A's quick ratio exceeds B's, then we can be certain that A's current ratio is also larger than B's.

b. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio.

c. Since the ROA measures the firm's effective utilization of assets without considering how these assets are financed, two firms with the same EBIT must have the same ROA.

d. Suppose all firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. However, firms face different operating conditions because, for example, the grocery store industry is different from the airline industry. Under these conditions, firms with high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios.

e. Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, a zero debt ratio and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow money, use it to buy back stock, and raise the debt ratio to 50% and the equity multiplier to 2.0. She thinks that operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This would probably not be a good move, as it would decrease the ROE from 7.5% to 6.5%.

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