A firm is analyzing two possible capital structures-30 and 50 percent debt ratios. The firm has total assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of 40 percent on ordinary income. If the interest rate on debt is 7 percent and 9 percent for the 30 percent and the 50 percent debt ratios, respectively, the amount of interest on the debt under each of the capital structures being considered would be ________.
A) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $225,000
B) 30 percent debt ratio: $245,000 and 50 percent debt ratio: $225,000
C) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $250,000
D) 30 percent debt ratio: $135,000 and 50 percent debt ratio: $175,000

Question

Quizplus · Accepted Answer

Under 30% debt ratio:
Total assets = $5,000,000
Equity = 70% x $5,000,000 = $3,500,000
Debt = 30% x $5,000,000 = $1,500,000
Interest on debt = 7% x $1,500,000 = $105,000

Under 50% debt ratio:
Total assets = $5,000,000
Equity = 50% x $5,000,000 = $2,500,000
Debt = 50% x $5,000,000 = $2,500,000
Interest on debt = 9% x $2,500,000 = $225,000

Therefore, the best choice is a 30% debt ratio as it has a lower interest expense.

A Firm Is Analyzing Two Possible Capital Structures-30 and 50