i topic: advantages of long-term debt to the issuer and the investor Debt securi
ID: 2819653 • Letter: I
Question
i
topic: advantages of long-term debt to the issuer and the investor
Debt securities increase the financial risk to the firm, since the firm's default can result in bankruptcy Debt securities can offer more stable returns and lower-risk investment altenatives than equity securities. Does the preceding statement indicate an advantage or a disadvantage to the issuer or the investor in debt financing? Does the preceding statement indicate an advantage or a disadvantage to the issuer or the investor in debt financing? O Advantage to the issuer O Advantage to the investor O Disadvantage to the investor Disadvantage to the issuer Financial theory states that the use of debt financing (also called financial leverage) increases the borrowing firm's earnings per share (EPS)-assuming that everything else remains constant. Use the following example to prove or disprove the hypothesis: Assume that International Imports (12) generates annual sales of $1,125,000 using total assets of $500,000. It has an operating profit margin (EBIT/sales) of 45%, a tax rate of 35%, and 100,000 shares of common stock outstanding. These shares have a par value of $5 per share. Currently, the company is financed solely with common stock, but its management is considering selling sufficient debt to bring its debt ratio to 4S%. These debt securities, which will carry an interest rate of 15%, will be used to repurchase an equal value of shares of common stock, with the shares valued at their par value. Given this information, answer the questions in the following table: Presale Information $329,063 $3.29 What is the firm's current net income? What is the firm's current earnings per share? Postsale Information How many shares of common stock will the firm have outstanding if it sells its new debt? what will be the firm's earnings per share if it sells the new debt? Type here to searchExplanation / Answer
(i) Debt securities increase the financial risk to the firm, since the firm's default can result in bankruptcy.
The above statement indicates disadvantage to the issuer. If the issuer makes any default in the payment of interest on debt or repayment of any portion of debt, the issuer can be put to bankruptcy. In case of falling profits, the issuer may find it difficult to pay interest on debt regularly, hence issue of debt increases the financial risk of the issuer.
(ii) Debt securities can offer more stable returns and lower risk investment alternatives than equity securities.
The above statement indicates advantage to the investor. In comparison to equity securities, debt securities provide fixed income to the investors in the form of interest. Equity securities are risky since their value fluctuates more frequently. Market value of debt,more or less, remains same. In other words, there are low fluctuations in the value of debt securities and hence these carry low risk.
(iii)
Post sale impact
Required debt ratio = 45%
Debt ratio = Debt/Total assets
Hence, debt to be issued = 500,000 x 45%
= $225,000
Debt proceeds will be used to buy common stock.
Hence, number of shares to be bought back = 225,000/5
= 45,000
Hence, number of shares outstanding = 100,000 - 45,000
= 55,000
Kindly give a positive rating if you are satisfied with the answer. Feel free to ask if you have any doubts. Thanks.
Sales 1,125,000 EBIT 1,125,000 x 45% = 506,250 Less: tax 506,250 x 35% = - 177,187 Net income $329,063 Number of shares outstanding 100,000 Earnings per share 329,063/100,000 = $3.29Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.