4. Deht management ratlos a Aa Companies have the opportunity to use varying amo
ID: 2617631 • Letter: 4
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4. Deht management ratlos a Aa Companies have the opportunity to use varying amounts of different sources of financing to acquire their assets, Induding Intermal and extenal sources, and debt (borrowed) and equity funds Aunt Dottie's Linen Inc. reported no long-term debt in its imost recent balance sheet. A company with no debt on is books is referred to as O A company with leverage, or a leveraged company O A company with no leverage, or an unleveraged company which of the following is true about the leveraging effect? O Interest on debt is a tax deductible expense, which means that it can reduce a fim's taxable income and tax O Interest on debt can be deducted from pre-tax income, resulting in a greater taxable income and a smaller available operating income. Green Penguin Pencl Company has a total asset turnover ratio of 8.50x, net annual sales of $25 million, and operating expenses of $11 million (including depreciation and amortization). on its balance sheet and income statement, respectively, it reported total debt of $250 million on which it pays a 11% interest rate. To analyze a company's financial leverage situation, you need to measure the firm's debt management ratios. Based on the preceding information, what are the values for Green Penguin Pencil's debt management ratios? Ratio Value Debt ratlo Times-interest-eamed ratio Green Penguin pencl Company raises around from creditors for eech dollar of equity Influenced by a fim's ability to make interest peyments and pay beck its debt f ll eise is equal, creditors would prefer to give loans to companies with times-inberest-eamed rabios (TIE)Explanation / Answer
Answer- 4:
a)
Aunt Dottie’s Linen Inc. is a company with no leverage or an unleveraged company. Usually debt is used as a leverage to magnify the earnings available to shareholders, because interest on debt is a deductible expense for income tax thus reduce the tax liability and increase earnings available for shareholders.
b)
Option A is correct, interest on debt is a tax deductible expense, which means that it can reduce a firm’s taxable income and tax obligation.
c)
Green Penguin Pencil Company:
Total Assets Turnover = 8.50 times
Net Annual Sales = 25 million
Operating Expense = 11 million
Total Debt (11%) = 2.50 million
Debt Ratio = Total Debt / Total Assets
Total assets can be calculated from assets turnover ratio. As assets turnover ratio = Net Sales / Total Assets, so total assets = Net Sales / Asset turnover ratio:
Total Assets = 25/8.50 = 2.94 million
Debt Equity Ratio = 2.50 / 2.94 = 0.85 or 85%
Times-interest earned Ratio = EBIT / Interest Charge
EBIT = 25 – 11 = $ 14 million
Interest Charge = 2.50 * 11% = 0.275 million
Times-interest earned ratio = 14 / 0.275 = 50.91 times
d)
Total Assets = Total Debt + Shareholders Equity
Total Assets = 2.94 million
Total Debt = 2.50 million
Then total equity = 2.94 – 2.50 = 0.44 million
So, Green Penguin Pencil Company raise around $ 5.68 (2.50/0.44) from creditors for each dollar of equity.
e)
Creditors would prefer to give loans to companies with HIGH times interest earned ratio.
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