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Exercise 10-16 (Algo) Applying debt-to-equity ratio LO A2
Montclair Company is considering a project that will require a $620,000 loan. It presently has total liabilities of $160,000 and total
assets of $680,000.
1. Compute Montclair's (a) current debt-to-equity ratio and (b) the debt-to-equity ratio assuming it borrows $620,000 to fund the
project.
2. If Montclair borrows the funds, does its financing structure become more or less risky?



Answer :

GinnyAnswer
Montclair Company's current debt-to-equity ratio can be calculated by dividing total liabilities ($160,000) by total equity. Since Total Equity = Total Assets - Total Liabilities, we can find Total Equity by subtracting Total Liabilities from Total Assets. Thus, Total Equity = $680,000 - $160,000 = $520,000. 1. To compute the current debt-to-equity ratio: a) Debt-to-Equity Ratio = Total Liabilities / Total Equity b) Substituting the values: Debt-to-Equity Ratio = $160,000 / $520,000 ≈ 0.31 or 31% 2. If Montclair borrows $620,000 for the project, the new debt-to-equity ratio can be calculated by adding the loan amount to the total liabilities and recalculating the ratio. a) New Total Liabilities = $160,000 + $620,000 = $780,000 b) New Total Equity = $680,000 (no change) c) New Debt-to-Equity Ratio = $780,000 / $520,000 ≈ 1.50 or 150% Therefore, if Montclair borrows the funds, its financing structure becomes riskier as the debt-to-equity ratio increases significantly from 31% to 150%. This indicates a higher proportion of debt to equity in the company's capital structure, which implies increased financial risk.

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