Question

Exercise 10-15 Applying debt-to-equity ratio LO A3 Montclair Company is considering a project that will require a $500,000 loan. It presently has total liabilities of $220,000 and total assets of $620,000 1. Compute Montclair's (a current debt-to-equity ratio and (b) the debt-to equity ratio assuming it borrows $500,000 to fund the project. 2. If Montclair borrows the funds, does its financing structure become more or less risky? Choose Numerator: Choose Denominator: Debt-to-Equity Ratio If Montclair borrows the funds, does its financing structure become more or less risky? < Prev 17 of 17 !! Next >

Answer 1

1.a)Current debt to equity ratio can be computed as:

Debt to equity ratio=Total liabilities/Total equity

Equity=Assets-Liabilities

Equity=$620,000-$220,000

Equity=$400,000

Debt to equity ratio=$220,000/$400,000

Debt to equity ratio=0.55 or 55%

1.b) Debt to equity ratio if $500,000 is borrowed for funding the project can be computed as :

As $500,000 is borrowed both the liabilities and assets would increase by $500,000

Thus Liabilities=$220,000+$500,000=$720,000

Assets=$620,000+$500,000=$1,120,000

Equity=$1,120,000-$720,000=$400,000

Thus, debt to equity ratio=$720,000/$400,000

Debt to equity ratio=1.80 or 180%

2. As the higher the debt to equity ratio the higher is the financial risk involved ,if funds are borrowed the amount of equity remains the same but amount of debt increases , if the debt increases in the capital structure , the financing becomes more risky , the debt to equity ratio computed is higher after borrowing the funds thus financing structure become more risky.