A new firm is developing its business plan. It will require $600.000 of assets,

Question

A new firm is developing its business plan. It will require $600.000 of assets, and it projects $435,000 of sales and $350,000 of operating costs for the first year. The firm is quite sure of these numbers because of contract 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. What is the maximum debt ratio the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt ratio)

Explanation / Answer

we know that the formula for calculating the TIE ratio is TIE ratio = EBIT / interest But EBIT = Sales - Operating costs = $435,000 - $350,000 = $85,000 Interest = ? TIE ratio = 4.0 Substituting these values in the above ratio, we get 4.0 = $85,000 / interest Interest = $85,000 / 4.0 = $21,250 Therefore, the interest expense in dollars is $21,250 which is 7.5% of the debt Calculating the debt ratio: Debt amount = Interest amount / Debt rate = $21,250 / 7.5% = $21,250 / 0.075 = $283,333 Therefore, the debt ratio = Total debt / TOtal assets = $283,333 / $600,000 = 0.472 times The firm can use the maximum debt ratio 0.472 times so that the TIE ratio will not fall below 4.0

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