Question

Debt Management Ratios You are considering a stock investment in one of two firms (LotsofDebt, Inc. and LotsofEquity, Inc.), both of which operate in the same industry. LotsofDebt, Inc. finances its $30 million in assets with $29 million in debt and $1 million in equity. LotsofEquity, Inc. finances its $30 million in assets with $1 million in debt and $29 million in equity. Calculate the debt ratio and equity multiplier for the two firms.

Answer 1

The debt ratio and equity multiplier for LotsofDebt, Inc. are 96.67% and 30, respectively, indicating high leverage. For LotsofEquity, Inc., these ratios are 3.33% and approximately 1.03, suggesting a conservative financial structure with low leverage.

Step-by-step explanation:

Debt Management Ratios Calculation

To calculate the debt ratio and the equity multiplier for both LotsofDebt, Inc. and LotsofEquity, Inc., we can use the following formulas:

• Debt Ratio = Total Debt / Total Assets
• Equity Multiplier = Total Assets / Total Equity

For LotsofDebt, Inc.:

• Debt Ratio = $29 million / $30 million = 0.9667 or 96.67%
• Equity Multiplier = $30 million / $1 million = 30

For LotsofEquity, Inc.:

• Debt Ratio = $1 million / $30 million = 0.0333 or 3.33%
• Equity Multiplier = $30 million / $29 million = 1.0345 or approximately 1.03

These ratios indicate that LotsofDebt, Inc. is highly leveraged with a much higher proportion of debt financing, whereas LotsofEquity, Inc. uses primarily equity to finance its assets.