Compute the times interest earned ratio

Question

Case Scenario:

McGraw Industries, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm’s management has been instructed by its board to institute programs that will allow it to operate more efficiently, earn higher profits, and, most important, maximize share value.

In this regard, the firm’s chief financial officer (CFO), Ron Lewis, has been charged with evaluating the firm’s capital structure. Lewis believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm’s capital structure, Lewis has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures—A (30% debt ratio) and B (50% debt ratio)—that he would like to consider.

Lewis expects the firm’s earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm has a 40% tax rate.

TO DO:

1. Use the current level of EBIT to calculate the times interest earned ratio for each capital structure. Evaluate the current and two alternative capital structures using the times interest earned and debt ratios.

2. On the basis of your findings in parts c and d, which capital structure would you recommend? Why?

And B (50% debt ratio)—that he would like to consider.

Lewis expects the firm’s earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm has a 40% tax rate.

                                                        Capital structure^a

                                          Current                        A                          B

Source of capital             (10% debt)           (30% debt)            (50% debt)

 

Long-term debt                     $1,000,000            $3,000,000             $5,000,000

   Coupon interest rate b             9%                        10%                     12%

Common stock                   100,000 shares       70,000 shares        40,000 shares

Required return on equity,ks^c     12%                        13%                      18%

A These structures are based on maintaining the firm's current level o $10,000,000 of total financing.

B Interest rate applicable to all debt.

C Market-based return for the given level of risk.