Question

A new firm is developing its business plan. It will require $715,000 of assets (which equals total invested capital), 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 4.0, and if the TIE falls below this level the bank will call in the loan and the firm will go bankrupt. The firm will use only debt and common equity for financing. What is the maximum debt to capital ratio (measured as debt/total invested capital) the firm can use

Answer 1

The maximum debt to capital ratio (measured as debt/total invested capital) the firm can use is 44.29%.

Maximum debt to capital ratio:

TIE:

TIE = EBIT / Interest

EBIT =$450,000 -$355,000

EBIT= $95,000

Interest:

4 = $95,000 / Interest

Interest = $95,000 / 4 = $23,750.

Amount of debt:

Amount of debt=$23,750 / .075

Amount of debt= $316.666.70

Debt Ratio:

Debt ratio= $316,666.70 / 715,000 ×100

Debt ratio=44.289%

Debt ratio=44.29%(Approximately)

Inconclusion the maximum debt to capital ratio (measured as debt/total invested capital) the firm can use is 44.29%.

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