Question

Montclair Company is considering a project that will require a $670,000 loan. It presently has total liabilities of $135,000 and total assets of $705,000. 1. Compute Montclair’s (a) current debt-to-equity ratio and (b) the debt-to-equity ratio assuming it borrows $670,000 to fund the project. 2. If Montclair borrows the funds, does its financing structure become more or less risky?

Answer 1

Answer and Explanation:

1. a. The computation of the current debt-to-equity ratio is shown below:-

Equity = Total Assets - Total Liabilities

= $705,000 - $135,000

= $570,000

Debt-to-equity ratio = Total Liabilities ÷ Equity

= $135,000 ÷ $570,000

= 23.68%

b. The computation of the debt-to-equity ratio is shown below:-

Debt-to-equity ratio = Total Liabilities ÷ Equity

= ($670,000 + $135,000) ÷ $570,000

= $805,000 ÷ $570,000

= $1.41

2. Because the higher the debt-to-equity ratio is the greater the financial risk involved, if funds are lent, the amount of equity stays the same while the amount of debt increases, as the debt rises in the capital structure, the funding is more risky, the debt-to-equity ratio measured becomes greater after borrowing the money, thereby raising the risk of the financing system.