### CFA Practice Question

A firm's cost of equity is 12%, which reflects a 4% premium over the cost of its long-term debt. The firm has an EBIT of \$27,900 and \$65,000 in debt. The firm is planning to increase its debt by \$15,000, which will raise the cost of debt by 1% for the additional amount.

What is the change in the interest coverage ratio due to the additional debt?
A. -27.84%
B. -18.82%
C. -20.67%
Explanation: Cost of debt = Cost of equity - Risk premium = 12 - 4 = 8%
Current interest: 0.08 x 65,000 = 5,200
Cost of additional 15,000 in debt is 9% (= 8 + 1).
0.08 x 65,000 + 0.09 x 15,000 = 6,550
Current interest coverage ratio = EBIT / Interest = 27,900 / 5,200 = 5.37
New interest coverage ratio = 27,900 / 6,550 = 4.26
Change in interest coverage ratio = (4.26 - 5.37) / 5.37 = -0.2067, or -20.67%

User Comment
danlan Simply calculate the interest change:

Before: 65000*8%=5200
After: 65000*8%+15000*9%=6550

change is 5200/6550-1=-20.67%
Analizer How did Analystnotes arrive at the 8%. That is the only aspect I don't understand.
vikram59 4% premium on cost of equity. Equity = 12%, therefore debt =8%
grezavi Nice one "danlan"
Skrills keep em coming danlan. i like your notes the best