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Capital Structure Theories^323

r = cost of debt

D/E = debt-equity ratio

t = tax rate

Applying the above equation to Korex Limited when its D/E ratio is 1, we may calculate

the value of ROE for two values of ROI, namely, 15 per cent and 20 per cent.

ROI= 15%

ROE = 115 + (15 - 10) 1] (0.5)= 12∑5%

ROI = 20 per cent

ROE = [20 + (20 - 10) 1] (Q.5) = 15.0%

These results, as expected, are in conformity with our earlier analysis.

Assessment of Debt Capacity

Employment of debt capital entails two kinds of burden: interest payment and principal

repayment. To assess a firm's debt capacity we lode at its ability to meet these committed

paymens. This may be judged in terms of:

l Coverage ratios

l Coverage Ratios

l Inventory of resources

Coverage Ratios

A coverage ratio shows the relationship between a committed payment and the source;

for that payment. The coverage ratios commonly used are: interest coverage ratio,

cash flow coverage ratio, and debt service coverage ratio.

Fig. 3: Relationship between ROI and ROE Under Alternative Capital Structure

20

15

10

5

ROE

B

A

ROI

5 10 15 20 25 30