Question

1. Explain why the costs of debt and equity are expected to increase as leverage increase? (Note: We didn't cover this directly in class, but we talked about this indirectly. Hint: It has to do with risk) 2. If the Debt-to-Asset ratio is .46, what is the Debt-to-Equity ratio? 3. Suppose a farm business indicates an average cost of farm debt of 12%, a rate-of-return on farm assets of 15%, and a debt-to-equity ratio of 1.0. What is the firm's rate-of-return on farm equity? What would be its rate-of-return on farm equity if the debt-to-equity ratio were 2.0? (HINT: I do not give you Asset-to-Equity, but you can calculate it) 4. Use Table 1 and Table 2 to calculate the following ratios. (Use Net Income, not EBIT, for net income and Total Sales, not gross profit margin, for sales numbers) a. Profit Margin b. Asset Turnover Ratio C. Debt-to-Asset d. Debt-to-Equity e. Current Ratio f. Quick Ratio (Also called Acid Test Ratio) g. Return on Equity h. Return on Assets

Answer 1

1]	As leverage increases the riskiness of the firm increases as
	it will be saddled with the fixed interest cost that will have
	to be met irrespective of the level of EBIT and the repayment
	schedule, if any, of the debt which, will have to be adhered
	to.
	When the firm's riskiness increases beyond an acceptable
	level both the debt suppliers and the equity suppliers will
	ask for more return to compensate them for the increased
	riskiness.
2]	Debt equity ratio = 0.46/(1-0.46) =	0.85
3]	Cost of levered equity = 15%+(15%-12%)*2 =	21.00%
5]
a]	Profit margin = 435000/17068000 =	2.55%
b]	Asset turnover ratio = 17068000/38500000 =	0.44
c]	Debt-to-Asset = 17295000/38500000 =	0.45
d]	Debt-to-Equity = 17295000/21205000 =	0.82
e]	Current ratio = 18392000/9023000 =	2.04
f]	Quick ratio = (851000+4068000)/9023000 =	0.55
g]	Return on equity = 435000/21205000 =	2.05%
h]	Return on assets = 435000/38500000 =	1.13%