14. Lear, Inc., has $800,000 in current assets, $350,000 of which are considered permanent current assets. In addition, the firm has $600,000 invested in fixed assets.

Question

a. Lear wishes to finance all fixed assets and half of its permanent current
assets with long-term financing costing 10 percent. Short-term financing
currently costs 5 percent. Lear’s earnings before interest and taxes are
$200,000. Determine Lear’s earnings after taxes under this financing plan.
The tax rate is 30 percent.
b. As an alternative, Lear might wish to finance all fixed assets and permanent
current assets plus half of its temporary current assets with long-term financing.
The same interest rates apply as in part a. Earnings before interest and
taxes will be $200,000. What will be Lear’s earnings after taxes? The tax
rate is 30 percent.
c. What are some of the risks and cost considerations associated with each of
these alternative financing strategies?

Answer 1

a.
175,000(half of working capital)+600,000(fixed assets)=775,000 in assets to be financed with LT Debt (10% interest rate)

The other $175,000(half of permanent current) will be financed at 5% as well as the 450,000 in variable current assets. ($625,000x.05) The company has no equity! (It's an American bank)

EBIT: 200,000
LT Expense: 77500
ST Expense: 31250
EBT: 108750
Taxes (30%): 32625

Net Income: 76125

b.

225,000(half of variable current assets)+350,000(permanent current)+600,000(all fixed)=1175000 borrowed at 10%

EBIT: 200,000
LT Expense: 117500
ST Expense: 11250
EBT: 71250
Tax@30%: 21375
Net Income: 49875

c. The main part to these questions is the idea of the matching principle, that is, long-term needs ought to be financed with long term liabilities. The cost of long-term debt is greater, in this case 10% versus 5%, but provides for a stable funding source. Short term debt only has a period of 1 year at its max, and then it must be renewed. One problem that can be faced is difficulty in procuring short-term loans when they are needed. Fixed assets and current assets that are considered to be permanent (known as working capital) need to be financed with LT-debt. On the other hand, financing too much of current assets with LT-debt is expensive and obviously (in the examples above) affects your bottom line.