Saffron Industries most recent balance sheet reports total assets of $42,000,000, total liabilities of $16,000,000 and stockholders' equity of $26,000,000. Management is considering using $3,000,000 of excess cash to prepay $3,000,000 of outstanding bonds. What effect, if any, would prepaying the bonds have on the company's debt-to-equity ratio?
A)Prepaying the debt would cause the firm's debt-to-equity ratio to improve from .62 to .50.
B)Prepaying the debt would cause the firm's debt-to-equity ratio to improve from .62 to .57.
C)Prepaying the debt would cause the firm's debt-to-equity ratio to worsen from .62 to .50.
D)Prepaying the debt would cause the firm's debt-to-equity ratio to worsen from .62 to .57.
E)Prepaying the debt would cause the firm's debt-to-equity ratio to remain unchangeD.Current Situation: Total Assets = Total Liabilities + Stockholders' Equity

Question

Quizplus · Accepted Answer

The debt-to-equity ratio is calculated by dividing total liabilities by stockholders' equity. Currently, Saffron Industries' debt-to-equity ratio is 16,000,000/26,000,000 = 0.62. If the company were to use $3,000,000 of excess cash to prepay $3,000,000 of outstanding bonds, total liabilities would decrease by $3,000,000, and stockholders' equity would remain the same. Therefore, the new debt-to-equity ratio would be 13,000,000/26,000,000 = 0.5. This means that prepaying the bonds would cause the firm's debt-to-equity ratio to improve from 0.62 to 0.5. So, the correct answer is A.

Saffron Industries Most Recent Balance Sheet Reports Total Assets of $42,000,000