Question

5. More on debt management ratios Aa Aa E The extent of financial leverage in a firm Debt ratios measure the proportion of total assets financed by a firm's creditors. Cute Camel Woodcraft Company has a debt-to-equity ratio of 2.00, compared to the industry average of 2.40. Its competitor Purple Lemon Woodcrafters, however, has a debt-to-equity ratio of 1.60. Based on what debt-to-equity ratios imply, which of the following statements is true? O Cute Camel has greater financial risk as compared to Purple Lemon but lower than the average financial risk in the industry. Cute Camel has higher creditworthiness as compared to Purple Lemon. Purple Lemon has a greater risk of bankruptcy than Cute Camel. Purple Lemon's creditors face higher risk than the average financial risk in the industry. Suppose the stock price of Purple Lemon Woodcrafters increases by 15%. What impact will it have on its market-to-debt ratio if nothing changes in the company's balance sheet? The market debt ratio will decrease, reflecting a decrease in the financial risk of the company. The market debt ratio will decrease, reflecting an increase in the financial risk of the company. The market debt ratio will increase, reflecting an increase in the financial risk of the company. The market debt ratio will increase, reflecting a decrease in the financial risk of the company. Purple Lemon Woodcrafters reported the following figures in its annual report. Data Collected (Millions of dollars) Year 1 EBITDA $700 Interest payments $70 Principal payments Lease payments Based on the information, Purple Lemon Woodcrafters has the ability to cover its fixed financial charges times.

Answer 1

Solution:

Question 1.

The debt to equity ratio of the firm Cute Camel is 2.0, industry average is 2.4 and competitor Purple Lemon has 1.60.

Higher the debt to equity ratio higher is the financial risk of the company. Hence we can say that the Cute Camel has greater financial risk as compared to Purple Lemon but lower than the industry

Hence option A is correct

Question 2.

Stock price increased by 15% and it means that the market value of equity is increased by 15%.

Market Debt Ratio = Total Liability / ( Total Liability + Market value of equity ).

Higher Market value of Equity means that the Market Debt ratio will decrease and it means that the financial risk of the company decreases.

Hence correct option is A )

Question 3 )

fixed charge coverage ratio = Earning before interest and taxes + Fixed payment / ( Fixed payment + Interest)

Fixed payment is Lease payment and principal repayment

fixed charge coverage ratio = (700 + 56+32) / ( 56+32+70) = 788/158 = 4.99 = 5

Hence correct option is 5 times