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?

Explanation / Answer

Estimated profit = $760,000 - $625,000 = $135,000

Required TIE Ratio = 5.5x

Interest should be = $135,000 / 5.5 = $24,545.45

Minimum amount of debt firm can use = $24,545.45 / 7.5% = $327,273

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