[Anonymous]

Wiley Question –

Hi,

I am always confuse with a question like below. I don’t understand what exactly the question is asking about and I also have hard time to understand this statement: “This source of equity is exhausted when the firm reaches an investment level of 150,000.”

Can anyone help me to understand this please? Thank you!

A company has $1,500,000 of outstanding debt and $1,000,000 of outstanding common equity. Management plans to maintain the same proportions of financing from each source if additional projects are undertaken. If the company expects to have $60,000 of retained earnings available for reinvestment in new projects in the coming year, what dollar amount of new investments can be undertaken without issuing new equity?

Answer D is correct. The proportion of equity in the financial structure of the firm is the value of outstanding equity divided by the total value of all financing sources.

1,000,000/(1,000,000+1,500,000) = 0.4

Since the question states that the firm will maintain the same weight of each financing source, each dollar invested is composed of 40 cents of equity and 60 cents of debt. The first $60,000 of equity used in financing new projects is sourced from retained earnings. This source of equity is exhausted when the firm reaches an investment level of

$60,000 / .4 = $150,000.

When the level of investment exceeds this amount, equity financing must be raised externally.

 

 

[Anonymous]

Let me give this a try.

So the company has to maintain its debt:equity ratio. This ratio is 1,500,000:1,000,000 or simply 1.5:1. If the company has 60,000 of retained earnings (equity) than the equation becomes 1.5:1 = x:60,000 solving for x gives an amount of debt of 90,000. These two numbers are added together for the 150,000 that is the answer for the problem. Once the requirement is greater than 150,000 either the ratio must change or the company needs to issue more equity, both of which are not allowed per the problem.

hope this helps…and is even remotely understandable 🙂

[Anonymous]

I got it. That's very clear. Thank you very much Cpa2behopefully!!!!!

[Author]

Replies