Companies use different sources for financing their assets-internal resources as

Question

Companies use different sources for financing their assets-internal resources as well as external resources. Company A uses long-term debt to finance its assets, and company B uses capital generated from shareholders to finance its assets. Which company would be considered a financially leveraged firm? O Company A Company B Which of the following is true about the leveraging effect? Interest on debt can be deducted, leading to higher taxable income and a lower available operating income. O Interest on debt can be deducted, leading to lower taxable income and lower taxes. Dual Purposes Products Co. has a total asset turnover ratio of 8.50x, and it generated net annual sales of $25 million by incurring operating expenses of $11 millon (including depreciation and amortization). Dual Purposes Products Co. reported on its balance sheet a total debt of $1.75 million and pays 11% on its outstanding debt. To analyze a company's financial leverage situation, you need to measure the firm's debt management ratios. Based on the preceding information, what are the values for Dual Purposes Products Co.'s debt management ratios? Ratio Value Debt ratio Trimes-interest-earned ratio 7 Influenced by a firm's ability to make interest payments and pay back its debt, if all else is equal, creditors would prefer to give loans to companies with times-interest-earned ratios (TIE)

Explanation / Answer

Question 1 Company A is the financially leveraged Firm since it's using debt to finance its assets.

Question 2 Interest on debt is tax deductible and thus, the 2nd statement is correct. Interest cost leads to lower taxable income and lower taxes.

Question 3 This one's a bit tricky. We're given total sales of $25 million and asset turnover ratio of 8.5 times. This means the sales this year was 8 times the total assets, which would give us total assets of 25/8.5 = $2.94 million. We know that there's a total debt of $1.75 million, then equity can be worked out as follows:

$2.94 - 1.75 = $1.19 million worth of Equity.

Further, the interest cost on the debt is 11%. Interest amount works out to be: $1.75*11% = 0.1925 million

Then, Debt ratio = Debt/Equity, or 1.75/1.19 = 1.47 times

Times interest earned ratio = Operating profit/Interest cost = 14/0.1925 = 72 times

Question 4 Creditors would prefer to give loans to companies with 'higher' TIE ratios.

Hope that helps! :)

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