Chapter 14, Problem 12E

To determine

Debt-to-Equity Ratio:

It is a financial ratio which compares the borrowed funds and owned funds to determine the proportion of debt and equity invested in the total asset of a company. It is generally computed by dividing the total liabilities or debt by the total stockholder’s equity of a company.

To determine:

1. Computation of (a) Present debt-to-equity ratio and (b) the debt-to-equity ratio assuming it borrows $500,000 to fund the project.

2. Evaluate and discuss the level of risk involved if Montclair borrows the funds to pursue the project.

Answer to Problem 12E

Solution:

1. (a) Present Debt-to-Equity is 0.55 and (b) Potential Debt-to-Equity is 1.80.

2. If Montclair borrows the funds to pursue the project, the level of risk increases with the increase in the proportion of debt in capital of the company.

Explanation of Solution

Explanation:

$\begin{array}{l}1\left(a\right)PresentDebt-to-EquityRatio=\frac{TotalLiabilities}{TotalStockholders’Equity}\hfill \\ =\frac{\$220,000}{\$400,000}\hfill \\ =0.55\hfill \\ \hfill \\ *TotalStockholders’Equity=TotalAssets–TotalLiabilities\hfill \\ =\$620,000-\$220,000\hfill \\ =\$400,000\hfill \\ \hfill \\ \left(b\right)PotentialDebt-to-EquityRatio=\frac{TotalLiabilities}{TotalStockholders’Equity}\hfill \\ =\frac{\$720,000}{\$400,000}\hfill \\ =1.80\hfill \\ \hfill \\ *TotalLiabilities=PresentLiabilities+PotentialLiabilities\hfill \\ =\$220,000+\$500,000\hfill \\ =\$720,000\hfill \end{array}$

2.

If the company borrows the fund for the project, the debt-to-equity ratio is 1.80 which means that the borrowed funds 80% more than the owned funds. The debt of a company comes with liability obligation of interest and repayment of the principal. Montclair must pay the interest and the principal amount whether the company makes profit from the project or not. So it increase the level of risk in pursuing the project with the borrowed funds.

Conclusion

Conclusion:

Hence it is concluded that the debt-to-equity of Montclair increases to 1.80 when it borrows $500,000 additional liabilities for the project which increases the level of risk regarding the payment of interest and repayment of principal amount.