A firm has an EBIT margin that could easily fall to as low as 4% in a realistic worst case scenario; and because it is rather vulnerable to costs of financial distress, the firm wishes to target an EBIT interest coverage ratio of 3× for this unfavorable scenario. You have the following information from its most recent accounts:

EBIT 550

Sales 8000

Debt 625

Equity (book value) 1975

Equity (market value) 4375

Answer the questions that follow, assuming that rating criteria and current bond market conditions are described by:  

Rating Criteria

Credit rating                                A                   BBB               BB

Debt Ratio @ BV (D/Cap)        0.2 to 0.35    0.35 to 0.5    0.5 to 0.6

Interest coverage (average)   10                    5.5                  3

Market Yields

Rating                                       A                      BBB               BB

Interest rate                             8%                   9%                 10%

a. What is the maximum amount of interest the firm thinks it can afford to pay? Then, what would its interest coverage ratio be if EBIT remains at its current level (rather than falling to 4% of sales)?

b. Determine the target level of debt for the firm, both in $ and as a ratio to capital. What rating is the target debt likely to obtain? [Hint: work out three different cases, assuming each of the credit ratings given in the table in turn, and then pick the answer that is internally consistent.]

c. Explain what the firm's CFO must do (Issue debt or equity? Retire debt? Buy back equity and/or pay a dividend? How much?) in order to reach the target capital structure that you propose.