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.

Question

Syed Amer Hussain · Accepted Answer

Final Answer : A, Explanation :  The debt-to-equity ratio is calculated by dividing total liabilities by stockholders' equity. The current debt-to-equity ratio is 16,000,000/26,000,000 = 0.62. If the company uses $3,000,000 of excess cash to prepay outstanding bonds, total liabilities will decrease by $3,000,000. Therefore, the new total liabilities will be $16,000,000 - $3,000,000 = $13,000,000. The stockholders' equity will remain the same at $26,000,000. The new debt-to-equity ratio will then be 13,000,000/26,000,000 = 0.50, improving the ratio from 0.62 to 0.50. Therefore, the correct answer is A.

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