Executive Fruit

In this scenario, the equity amount is only increased by the retained earnings. All other financing is taken as debt. The leverage ratios – debt ratio and interest coverage ratios are calculated. Under the first scenario of 10% interest rate, the debt ratio increases to 0.50 in 2007 assuming a sales growth rate of 10%. The interest coverage ratio decreases to 4.54.

Under the interest rate of 15%, the debt ratio increases to 0.512 and the interest cover decreases to 2.98. In both the cases the debt ratio is below 60% as desired by the bankers. Though in the scenario of 15% interest rate, the interest cover ratio falls quite a bit, but is still close to 3.0. 40% debt ratio – In this scenario, the equity is increased so as to maintain a constant debt ratio of 40%. Under the 10% interest rate, the debt ratio is 0.40 and the interest cover is quite healthy at 5.50%. The return on equity falls to 15.5% as compared to 17.62% in the earlier 10% scenario. Under the 15% interest rate scenario, the interest cover falls to 0.367 and the return on equity falls to 13.87% as compared to 15.49% in the earlier scenario.

Looking at the leverage ratios and the return on equity, when the interest rates are 10%, the debt financing is better. This has a higher Return on Equity and the debt ratio is lower than 60% and the interest cover is also good at 4.54

Under the 15% interest rate scenario, the debt ratio rises only marginally, but the interest cover falls quite a bit. Also the difference in Return on Equity in this case is 1.62%. Executive fruit may keep the equity constant scenario here also, but there is an increased financial risk and so it may be better to go for increasing equity.