Question

Debt ratios measure the proportion of total assets financed by a firm’s creditors.

Hackworth Co. has a debt-to-equity ratio of 3.00, compared to the industry average of 2.40. Its competitor Markum’s Co., however, has a debt-to-equity ratio of 4.50. Based on what debt-to-equity ratios imply, which of the following statements is true?

Markum’s Co. has higher creditworthiness as compared to Hackworth Co.

Markum’s Co.’s creditors face lesser risk than the average financial risk in the industry.

Markum’s Co. has greater financial risk as compared to Hackworth Co. and to the average financial risk in the industry.

Hackworth Co.’s shareholders expect magnified returns but higher risk as compared to Markum’s Co.

Suppose the stock price of Hackworth Co. falls by 10%. 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 increase, reflecting a decrease 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 decrease, reflecting an increase in the financial risk of the company.

Data Collected (Millions of dollars)

	Year 1
EBITDA	$550
Interest payments	$55
Principal payments	$44
Lease payments	$25

Hackworth Co. reported the following figures in its annual report.

Based on the information, Hackworth Co. has the ability to cover its fixed financial charges   times.

Answer 1

1]

The first statement is not true. Markum’s Co. has lower creditworthiness as it has a higher debt equity ratio as compared to Hackworth Co.

The second statement is not true. Markum’s Co.’s creditors face higher risk as it has a higher debt equity ratio than the industry.

The third statement is true, as Markcum Co. has a higher debt equity ratio.

The fourth statement is not true. Markcum Co’s shareholders expect magnified returns but higher risk as compared to Hackworth Co, since Markcum Co. has higher leverage.

2]

Market debt ratio = book value of debt / (book value of debt + market value of equity).

If the stock price falls, the market value of equity will fall, and hence the market debt ratio will increase.

The market debt ratio will increase, reflecting an increase in the financial risk of the company.

3]

fixed financial charges coverage ratio = EBITDA / (interest + principal + lease)

fixed financial charges coverage ratio = $550 / ($55 + $44 + $25) = 4.44 times