Suppose that a firm has both fixed-rate and floating-rate debt outstanding. What effect will a decline...

Suppose that a firm has both fixed-rate and floating-rate debt outstanding. What effect will a decline in interest rates have on the firm’s times-interest-earned ratio? What about the ratio of the market value of debt to that of equity? Would you judge that leverage has increased or decreased?

Expert Solution

Ans:- To understand what effect will a decline in interest rates would have on firms time-interest- earned-ratio, first we need to understand what is time-interest-earned ratio.

Time interest earned ratio is given by Earnings before interest and Tax divided by Interest Payements.

Time Interest earned ratio = EBIT/ Interest payements.

This ratio is also known as interest coverage ratio and is calculated by dividing EBIT by Interest Payement. If the interest payements are decreased in time-interest-earned ratio given the EBIT constant then time-interest-earned ratio will increase.Therefore in this scenario time-interest-earned ratio will increase and also we can say that the firm has good capability to pay the interest payement.

Note:- Interest payement will reduce because interest rates will decline.

Debt to equity ratio will not have any effect due to change in interest payment because debt equity ratio will change if the firm issues additional debt or compensate or reedems its debt and debt equity ratio will also change when the firm decides to repurchase its common stock or issue any additional common stocks. Therefore debt to equity ratio will not have any effect due to decline in interest payement or in other words it will have zero impact on debt to equity ratio.

Leverage:- Leverage is nothing but an investment strategy used by the firms to finance their assets by means of various financial instrument or borrowed capital.

If the interest payement reduces or decline then it will surely have effect on the Leverage. If the interest payement is reduced then the overall effect on the leverage will decrease and if the interest payement is increased then the overall effect on leverage will increase. Therefore in this case it is given that the firms interest payement will decline therefore the overall effect on leverage will decrease.

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