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? (Note that by the term debt ratio I imply Debt/Total Assets from the 13th edition of our text, which in the 14th edition is called the Liabilities-to-assets ratio and is defined as Total liabilities/Total assets. Or assume account payable, accrual interest, and deferred taxes are all equal to zero).  

Explanation / Answer

Calculation of Earning Before Interest and Taxes:

Sales = $760,000, Opearting Cost and Cost of Goods Sold = $625,000

EBIT = $135,000 (760,000 - 625,000)

Times Interest Earned Ratio = EBIT / Interest

Given Ratio is 5.5

5.5 = 135,000 / X

X = 24,545.45 or Maximum Interest that Firm can Pay = $24,545.45

Maximum Debt Firm can Borrow = 24,545.45 / 7.5 x 100 = $327,272.72

Debt Ratio = Debt / Total Assets

Debt Ratio = 327,272.72 / 1,000,000 = 0.3272 or 32.72%

This is the Maximum Debt Ratio that Firm can Have.

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