Question

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.

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.

Could you please walk me through on how to get started.

Answer 1

First compute the interest paid annually. In (a), it is 10% of $600,000 plus 5% of $175,000. Subtract that from the 200,000 before T&I, and then take 30% off of that for taxes.

Do (b) similarly. The interest paid will be different.