Question 32 on page 108:

Based on Exhibits 2 and 3, as well as Holmstead’s assumption about future health care inflation, the debt-to-equity ratio calculated by Rickards for XYZ should be closest to:

A 2.69.

B 2.71.

C 2.73.

Exhibit 3 shows 100 bp increase would result in Benefit obligation change of + $93.

Answer is:C is correct. To calculate the debt-to-equity ratio, both liabilities and total equity need to be adjusted for the estimated impact of a 100-bp increase in health care costs. The proposed increase in health care costs will increase total liabilities and decrease equity by the same amount. Consequently, the debt-to-equity ratio changes as follows:

Sensitivity of benefit obligation to 100-bp increase = $93

Adjusted liabilities = $17,560 + $93 = $17,653

Adjusted equity = $6,570 – $93 = $6,477

Adjusted debt-to-equity ratio = $17,653/$6,477 = 2.7255 ≈ 2.73

Consequently, a 100-bp increase in health care costs increases the debt-to-equity ratio to approximately 2.73.

I don’t understand why we need to subtract 93 from equity. I understand that A = L + E and that would offset the liability increase but conceptually, why equity decrease?

Sorry for the dumb question,

Thanks