A firm maintains a capital structure with debt-equity ratio of 2/3 and has $24,000 earnings for...
A firm maintains a capital structure with debt-equity ratio of 2/3 and has $24,000 earnings for the year-end. The firm follows a residual dividend policy.
a. What is the maximum capital budget amount the firm can finance without raising external equity?
b. Suppose the firm's capital structure before financing the maximum capital budget consisted of $500,000 debt and $750,000 equity. Calculate the firm's debt ratio after financing the maximum capital budget in part (a).
Homework Answers
Answer (a):
Given that:
Debt equity Ratio = 2:3
Earnings = $24,000
The firm follows a residual dividend policy.
Debt financing of the capital budget = 24000 * 2/3 = $16,000
Maximum capital budget amount the firm can finance without raising external equity = 16000 + 24000 = $40,000
Maximum capital budget amount the firm can finance without raising external equity = $40,000
Answer (b):
Maximum capital budget = $40,000
Financed by:
Retained earnings = $24,000
Debt = $16,000
Assuming the firm's capital structure before financing the maximum capital budget consisted of $500,000 debt and $750,000 equity.
Post financing:
Debt = 500000 + 16000 = $516,000
Equity = 750000 + 24000 = $774,000
Total assets = 516000 + 724000 = $1,290,000
Firm's debt ratio after financing the maximum capital budget in part (a) = Laibilties / Total assets
= 516000 / 1290000
= 0.40 or 40%
Firm's debt ratio after financing the maximum capital budget in part (a) = 0.40 or 40%
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