Question

Three Piggies Enterprises has no debt. Its current total value is $76 million. Assume the company sells $35 million in debt.

Ignoring taxes, what is the debt–equity ratio? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Debt–equity ratio            

Assume the company’s tax rate is 38 percent. What is the debt–equity ratio? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Debt–equity ratio            

Answer 1

The value of the firm is the value of the debt plus the value of the equity. We can use this relationship to find the value of equity in each case. So, the debt–equity ratio with no taxes is:

V = E + D

$76,000,000 = E + $35,000,000

E = $41,000,000

Debt–equity ratio = $35,000,000 / $41,000,000

Debt–equity ratio = 0.85

With taxes, the value of the firm is:

V_L = V_U + T_CD

V_L = $76,000,000 + 0.38($35,000,000)

V_L = $89,300,000

With taxes, the equity becomes:

V = E + D

$89,300,000 = E + $35,000,000

E = $54,300,000

Debt–equity ratio = $35,000,000 / $54,300,000

Debt–equity ratio = 0.64