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7. A company currently has a debt-to-equity ratio of1.25. Common shareholder’s equity is $4,000,000, consisting of1.5 million shares outstanding with a current price of $28/share. Part of the company’s debt currently outstanding is $1,000,000 of convertible bonds. Each $1,000 par value bond can be converted into50 common shares at any time during the next three years. The coupon rate on the bonds is6 percent with interest paid annually.
Debt/Equity =1.25; Equity = $4,000,000
Debt =1.25 x $4,000,000 = $5,000,000
Shares issued on conversion: $1,000,000/$1,000/bond x50 shares/bond =50,000 shares
Equity Issued: $1,000,000
Debt Reduction: $1,000,000 resulting in $4,000,000 outstanding
New Debt/Capital ratio: Debt/(Debt + Equity) = $4,000,000/($4,000,000+$5,000,000) =
What I can remember from my accounting classes ....I would have to agree44.44%
Current Debt Equity Ratio:1.25:1
Equity is $4,000,000
Hence Debt is $4,000,000 X1.25 = $5,000,000 (including $1,000,000 Convertible Bonds)
If all the convertible bonds are converted, debt will come to $4,000,000 ($5,000,000-$1,000,000) and
New equity will be $5,000,000 (current $4,000,000 + Bond $1,000,000)
Hence the new DER will be $4,000,000 : $5,000,000 i.e.80%.
Answer is C.80%.
Note: the number of current equity shares, current price, conversion ratio & coupon rate are irrelevant for this question.
It should be44.444444%
I'll give it a shot.
A D/E ratio of1.25 or125% means that for each $ of equity correspond a1.25$ in debts. If the initial equity is4 Mil$, the debts are5 mil$ then the Total capital is9 mil$ (this would equal a Total Debt Ratio of0.55 or55%).
Increasing the equity by1 Mil$ (4+1=5) by converting the bonds and reducing the debts by1 Mil $ (5-1=4) would provide the following Debt/Capital ratio result:4 (new debts level)/9 (Total capital) =44.4%
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