Question

At the end of 2017, Montvale Associates borrowed $120,000 from the Bayliner Bank. The debt covenant specified that Montvale’s debt/equity ratio could not exceed 1.5:1 during the period of the loan. A summary of Montvale’s balance sheet after the loan follows. 2017 Assets Current assets $130,000 Noncurrent assets 350,000    Total assets $480,000 Liabilities and Shareholders’ Equity Current liabilities $130,000 Long-term liabilities 150,000 Shareholders’ equity 200,000    Total liabilities and shareholders’ equity $480,000

A) Compute Montvale’s debt/equity ratio immediately after the loan. (Round answer to 2 decimal places, e. g. 1.25.) B) How much additional debt can the company incur without violating the debt covenant? C) How large a dividend can the company declare and pay at the end of 2017 without violating the debt covenant? (Round answer to 0 decimal places, e. g. 125.) D) If Montvale had declared, but not yet paid, a $20,000 dividend before it took out the loan, could the company pay the dividend afterward without violating the debt covenant? Why or why not? (Round answer to 2 decimal places, e. g. 12.25.) New Debt/equity ratio Since debt/equity ratio is greater than or less than the maximum debt/equity ratio allowed under the debt covenant, Montvale could or not could pay the $20,000 dividend without violating its debt covenant.

Answer 1

Answer :

a.   

Debt/Equity Ratio = Total Liabilities ÷ Total Shareholders' Equity

= ($130,000 + $150,000) ÷ $200,000

= 1.40

b.

The maximum debt that Montvale can have outstanding is 1.5 times its total shareholders' equity. This means that the total debt Montvale can have outstanding is $300,000 (1.5 × $200,000). Since Montvale already has $280,000 of outstanding debt, it can incur an additional $20,000 in debt without violating its debt covenant.

c.

The minimum level of shareholders' equity that Montvale can have is total debt divided by 1.5. This means that the total shareholders' equity Montvale can have is $186,667 ($280,000 ÷ 1.5). Since Montvale currently has $200,000 of shareholders' equity, and since dividends decrease shareholders' equity, the maximum dividend that Montvale can declare is $13,333.

d.

If Montvale had declared, but not paid, a $20,000 dividend prior to obtaining the loan, then the $20,000 is already included in the current liabilities reported on the balance sheet. Paying the dividend would decrease both current assets and current liabilities by $20,000. Thus, the debt/equity ratio after paying the $20,000 would be 1.3 ([($130,000 – $20,000) + $150,000] ÷ $200,000). Since this ratio is less than the maximum debt/equity ratio allowed under the debt covenant, Montvale could pay the $20,000 dividend without violating its debt covenant.