A company has $1,500,000 of outstanding debt and $1,000,000 of outstanding common equity. Management plans to maintain the same proportions of financing from each source if additional projects are undertaken. If the company expects to have $60,000 of retained earnings available for reinvestment in new projects in the coming year, what dollar amount of new investments can be undertaken without issuing new equity?
A. $ 90,000
B. $0
C. $ 24,000
D. $150,000
Answer:D
D is corrent. The proportion of equity in the financial structure of the firm is the value of outstanding equity divided by the total value of all financing sources.
A is incorrect. This answer calculates the proportion of equity financing incorrectly as: Value of equity / value of debt = 1,000,000 / 1,500,000 = .667 so the investment level at which retained earnings would be exhausted is $60,000 / .667 = $90,000.
B is incorrect. The company has retained earnings to use as one source of project financing.
C is incorrect. This answer multiplies, rather than divides by, the weight equity represents in the financial structure. This solution is calculated as: $60,000 x .40 = $24,000.