Determining target leverage: A firm has an operating profit margin of 4% in a realistic worst case, and it is considered a moderately vulnerable business, so that it would be prudent to keep an interest coverage ratio of 3 in the realistic worst case. You have the following information from its most recent accounts:

EBIT $ 550

Sales $ 8,000

Debt $ 625

Equity (book value) $ 1,975

Equity (market value) $ 4,375

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.Determine a 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 scenarios, one for each of the credit ratings given in the table, and then pick the answer that is internally consistent.

b.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.