A company has a Times Interest Earned (TIE) ratio of 5.0. It is considering issuing new debt to buy back stock. Which of the following statements BEST describes the impact of this transaction on the company's solvency ratios?

Answer options:

Debt-to-Equity ratio will decrease; TIE ratio will increase.

Debt-to-Equity ratio will increase; TIE ratio will increase.

Debt-to-Equity ratio will increase; TIE ratio will decrease.

Debt-to-Equity ratio will decrease; TIE ratio will decrease.

How to approach this question

Analyze the components. Debt issuance = Higher Debt, Higher Interest. Stock Buyback = Lower Equity. D/E = Debt/Equity (Up/Down = Up). TIE = EBIT/Interest (Constant/Up = Down).

Full Answer

C.Debt-to-Equity ratio will increase; TIE ratio will decrease.✓ Correct

Issuing debt increases Total Debt. Buying back stock decreases Total Equity. Therefore, Debt-to-Equity (Debt/Equity) increases. The new debt carries interest, increasing Interest Expense. Assuming EBIT is unchanged, TIE (EBIT/Interest) decreases.

Common mistakes

Confusing the direction of the ratios; forgetting that debt carries interest.

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