Jones Inc. has a capital structure consisting of $8 million of liabilities and $10 million of equity. Included in liabilities is $1.2 million worth of exchangeable bonds. Immediately afterwards, Jones issues $0.7 million of redeemable preferred shares for cash proceeds and also calls its entire group of exchangeable bonds, netting a gain of $0.3 million on the bonds. Which of the following amounts is Jones’ revised debt to total capital ratio upon completion of the two new transactions? A) 0.421. B) 0.458. C) 0.728. D) 0.845. ----------------------------------------- Your answer: C was incorrect. The correct answer was A) 0.421. The $0.7 million of redeemable preferred shares are treated as debt and will increase liabilities. The exchange of the bonds results in a decrease in liabilities of $1.2 million and a gain of $0.3 million. The latter results in an increase in equity by $0.3 million (the net effect of the two transactions also decreases assets by $0.9 million). Liabilities = $8 million + $0.7 million - $1.2 million = $7.5 million Equity = $10 million + $0.3 million = $10.3 million Debt to total capital ratio = Liabilities / (Liabilities + Equity) = $7.5 million / ($7.5 million + $10.3 million) = 0.421. ------------------ Why isn’t 1.2m of the exchangeable bond converted to equity?
the statement says “and also calls its entire group of exchangeable bonds” It is an exchangeable bond with “call” feature…and in the above scenario it is “CALLed” by the issuer.