FINA CH 3
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CHAPTER 3
(3-2): Debt Ratio: Brite-Lite Bulbs has an equity multiplier of 3.2. The company’s assets are financed with some combination of long-term debt and common equity. What is the company’s debt ratio?
Brite-Lite Bulbs' equity multiplier of 3.2 indicates that its total assets exceed its common equity by 3.2. The debt ratio, calculated using the equity multiplier, shows that debt accounts for 68.75% of the company's assets, with common equity financing the remaining 31.25%. This indicates that the company's assets are financed by a mix of common equity and long-term debt.
(3-8): Assume you are given the following relationships for Haslam Corporation:
Sales/total assets
1.2×
Return on assets (ROA)
4%
Return on equity (ROE)
7%
Calculate Haslam’s profit margin and debt ratio.
Margin of Profit
The following relationship between Return on Assets (ROA) and Sales/Total Assets can be used to calculate the profit margin:
Profit Margin x Sales / Total Assets is ROA.
4% = Profit Margin x 1.2 / 4% = 3.33% is the profit margin.
Debt to Ratio
The link between Return on Equity (ROE) and Return on Assets (ROA) can be used to calculate the debt ratio:
ROA / (1 - Debt Ratio) equals ROE.
4% / (1 - Debt Ratio) = 7%
Ratio of Debt = 1-4% / 7% = 42.86%
(3-10): Cayman Auto has $600,000 of debt outstanding, and it pays an interest rate of 8% annually: Cayman Auto’s annual sales are $3 million, its average tax rate is 25%, and its net profit margin is 3%. If the company does not maintain a TIE ratio of at least 5 times, its bank will
refuse to renew the loan, and bankruptcy will result. What is Cayman Auto’s TIE ratio?
Cayman Auto pays an annual interest rate of 8% on $600,000 of outstanding debt. Its net profit margin is 3%, its average tax rate is 25%, and its yearly sales are $3 million.
We must determine the company's Earnings Before Interest and Taxes (EBIT) in order to compute the TIE ratio.
Net Income + Interest Expense + Taxes equals EBIT.
EBIT is calculated as follows: ($3 million x 3% / (1 - 25%) + ($600,000 x 8%) +
$90,000 + $48,000 + $30,000 is EBIT.
$168,000 is EBIT.
Calculating the Times-Interest-Earned (TIE) ratio is as follows:
Interest Expense / EBIT equals TIE.
$168,000 / $48,000 is TIE.
TIE is 3.5.
Cayman Auto's TIE ratio of 3.5 falls short of the minimum five-times requirement, causing the bank to refuse loan renewals and potentially lead to bankruptcy.
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