Question

Montclair Company is considering a project that will require a \(500,000 loan. It presently has total liabilities of \)220,000 and total assets of \(620,000.

1. Compute Montclair’s (a) present debt-to-equity ratio and (b) the debt-to-equity ratio assuming it borrows \)500,000 to fund the project.

2. Evaluate and discuss the level of risk involved if Montclair borrows the funds to pursue the project

Short answer

1. The debt-to-equity ratio

1. 0.55
2. 1.80 2.It is risky for the business to take a loan as the ratio will increase from 0.55 to 1.80

Step-by-step solution

Meaning of Debt-to-Equity Ratio

The debt-to-equity ratio specifies the portion of equity and debt component in financial the asset

Calculation of Montclair’s Debt- to- equity ratio

Part (a)

$\begin{array}{rcl}\mathit{D}\mathit{e}\mathit{b}\mathit{t}\mathbf{-}\mathit{t}\mathit{o}\mathbf{-}\mathit{e}\mathit{q}\mathit{u}\mathit{i}\mathit{t}\mathit{y}\mathbf{ }\mathit{r}\mathit{a}\mathit{t}\mathit{i}\mathit{o}& \mathbf{=}& \frac{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{ }\mathbf{l}\mathbf{i}\mathbf{a}\mathbf{b}\mathbf{i}\mathbf{l}\mathbf{i}\mathbf{t}\mathbf{i}\mathbf{e}\mathbf{s}}{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{ }\mathbf{e}\mathbf{q}\mathbf{u}\mathbf{i}\mathbf{t}\mathbf{y}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{220}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{400}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{0}\mathbf{.}\mathbf{55}\\ & & \end{array}$

Part (b)

$\begin{array}{rcl}\mathit{D}\mathit{e}\mathit{b}\mathit{t}\mathbf{-}\mathit{t}\mathit{o}\mathbf{-}\mathit{e}\mathit{q}\mathit{u}\mathit{i}\mathit{t}\mathit{y}\mathbf{ }\mathit{r}\mathit{a}\mathit{t}\mathit{i}\mathit{o}& \mathbf{=}& \frac{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{ }\mathbf{l}\mathbf{i}\mathbf{a}\mathbf{b}\mathbf{i}\mathbf{l}\mathbf{i}\mathbf{t}\mathbf{i}\mathbf{e}\mathbf{s}}{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{ }\mathbf{e}\mathbf{q}\mathbf{u}\mathbf{i}\mathbf{t}\mathbf{y}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{220}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{400}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{720}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{400}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{1}\mathbf{.}\mathbf{80}\\ & & \end{array}$

Working note:

Calculation of total equity

$\begin{array}{rcl}\mathit{T}\mathit{o}\mathit{t}\mathit{a}\mathit{l}\mathbf{ }\mathit{E}\mathit{q}\mathit{u}\mathit{i}\mathit{t}\mathit{y}& \mathbf{=}& \mathit{T}\mathit{o}\mathit{t}\mathit{a}\mathit{l}\mathbf{ }\mathit{A}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{-}\mathit{T}\mathit{o}\mathit{t}\mathit{a}\mathit{l}\mathbf{ }\mathit{L}\mathit{i}\mathit{a}\mathit{b}\mathit{i}\mathit{l}\mathit{i}\mathit{t}\mathit{i}\mathit{e}\mathit{s}\\ & \mathbf{=}& \mathbf{\$}\mathbf{620}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{220}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{\$}\mathbf{400}\mathbf{,}\mathbf{000}\\ & & \end{array}$

Evaluating the Risk

Generally, if a business entity has less debt-to-equity ratio, it is considered less risky for the business.

Montclair’s debt-equity ratio has increased from 0.55 to 1.80 after taking a project loan which means after the loan took the debtholders contributed $1.80 for each $1 contributed by equity holders, which is risky.