### 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 Contributed Comments8

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
arendb Shouldn't EBIT be adjusted to include the additional interest?
Ifi2703 You dont adjust, arendb, because that is your earnings BEFORE interest and taxes so it is unaffected by changes in interest expense etc. Your eventual net income will be affected but not the EBIT.
praj24 Man like Danlan! So simple