A new firm is developing its business plan. It will require $615,000 of assets, and it projects $450,000 of sales and $355,000 of operating costs for the first year. Management is reasonably sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires it to have a TIE of at least 4.0, and if the TIE falls below this level the bank will call in the loan and the firm will go bankrupt. What is the maximum debt ratio (measured as debt/assets) the firm can use?

The maximum debt ratio (measured as debt/assets) the firm can use is 51.5%.

Explanation:

Times Interest earned ratio = Earning Before Interest and Tax / Interest Expense

4 = ( Sales - operating costs ) / Interest Expense

4 = ( $450,000 - $355,000 ) / Interest Expense

4 = $95,000 / Interest Expense

Interest Expense = $95,000 / 4

Interest Expense = $23,750

Interest Expense = Total Debt x Interest on Debt

$23,750 = Total Debt x 7.50%

Total Debt = $23,750 / 7.50%

Total Debt = $316,667

Debt ratio = Total Debt / Total Assets

Debt ratio = 316,667 / 615,000

Debt ratio = 51.5%

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