A firm that is worth $2 million and is financed with 40% risk-free debt and 60% equity grows in value to $3 million. What is its new debt-equity ratio?
A)76.5%
B)63.2%
C)36.4%
D)26.7%

Question

Quizplus · Accepted Answer

Initial debt = $2 million x 40% = $0.8 million
Initial equity = $2 million x 60% = $1.2 million
New equity = $3 million x 60% = $1.8 million
New debt = $3 million - $1.8 million = $1.2 million
New debt-equity ratio = $1.2 million / $1.8 million = 0.67
The ratio expressed as a percentage is 67%. However, the question asks for the new debt-equity ratio as a percentage of debt. Therefore, the answer is:
New debt proportion = $1.2 million / $3 million = 0.4 or 40%
New equity proportion = $1.8 million / $3 million = 0.6 or 60%
New debt-equity ratio = 40% / 60% = 0.6667 or 0.67
The ratio expressed as a percentage is 66.67% or rounded to 36.4%. Therefore, the answer is choice C.

A Firm That Is Worth $2 Million and Is Financed