Question

When Debt to Equity Ratio is 2, state giving reason, whether this ratio will increase or decrease or will have no change in each of the following cases:
(i) Sale of Land (Book value ₹4,00,000) for ₹5,00,000; (ii) Issue of Equity Shares for the purchase of Plant and Machinery worth ₹10,00,000; (iii) Issue of Preference Shares for redemption of 13% Debentures, worth ₹10,00,000.

Answer 1

Debt-Equity Ratio = 2:1

Let Long-term loan = Rs 20,00,000

Shareholders’ Funds = Rs 10,00,000

(i) Sale of Land (Book Value Rs 4,00,000) for Rs 5,00,000- Decrease

Reason: This transaction will result increase in Shareholders’ Funds by Rs 1,00,000 as profit on sale of Land.

Shareholders’ Funds after adjusting profit on sale of land = 10,00,000 + 1,00,000 = Rs 11,00,000

`"Debt - Equity Ratio" = 2000000/1100000 = 1.81 : 1`

(ii) Issue of Equity share for the purchase of plant and Machinery worth Rs 10,00,000- Decrease

Reason: This transaction will increase the amount of Shareholders Fund by Rs 10,00,000 in the form of equity shares and have no effect on Long-term Loans.

Debt-Equity Ratio = `2000000/(100000 + 1000000) = 1 : 1`

(iii) Issue of preference Shares for redemption of 13% Debentures worth Rs 10,00,000- Decrease

Reason: This transaction will lead to decrease in Long-term Loan by Rs 10,00,000 in the form of redemption of debentures and increase in Shareholders’ Funds with the same amount in the form of Preference Shares.

Debt-Equity Ratio = `(2000000 - 1000000)/(1000000 + 1000000) = 0.5 : 1`