Question

The Morris Corporation has $450,000 of debt outstanding, and it pays an interest rate of 8% annually. Morris's annual sales are $2.25 million, its average tax rate is 40%, and its net profit margin on sales is 3%. If the company does not maintain a TIE ratio of at least 4 to 1, its bank will refuse to renew the loan and bankruptcy will result. What is Morris's TIE ratio? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

TIE ratio is Times Interest Earned

Formula is , TIE ratio=

EBIT=Earnings before interest and taxes

I=interest payments

Let's calculate these values

I=interest payments= Outstanding debt X interest rate=$450,000 X 8%=$36,000

So, I= $36,000

Now, EBIT= Net Profit + Interest Payments (I) + Tax paid

Net Profit= Sales X NetProfit Margin = $2,250,000 X 3% = $67,500

I= $36,000

Tax Paid=

where t = tax rate=40%=0.4

So, Tax Paid= ($67,500 X 0.4) /(1-0.4)= ($67,500 X 0.4)/0.6 = $27,000 / 0.6 = $ 45,000

Now, EBIT = $67,500 + $36,000 + $45,000= $148,500

TIE ratio= $148,500/$36,000= 4.125 = ~4.12 (rounding off to two decimal places)

Since the TIE ratio is better (more) than 4, bank will NOT declare bankruptcy.

Instead, the bank will accept to issue new loan.

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