A start-up company is seeking your advice concerning its debt ratio and capital

Question

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

Explanation / Answer

TIE (times-interest-earned) ratio = EBIT / INTEREST

=> 5.5X = $135,000 / INTEREST

   => INTEREST = 135,000 / 5.5

=> $24,545

So interest amount is this, then total amount of Debt to be = Interest amount / interest rate

=> $24,545 /7.5%

Total amount of debt = $327,273

=> %of debt = $327,273 / $1,000,000

=> 32.73 % (rounded off)

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