a. To determine Lear's earnings after taxes under this financing plan, we first need to calculate the interest expenses for both long-term and short-term financing.
For long-term financing:
Fixed assets = $600,000
Permanent current assets = $350,000
Total assets to be financed = Fixed assets + (0.5 * Permanent current assets) = $600,000 + (0.5 * $350,000) = $775,000
Long-term financing cost = Total assets to be financed * Long-term financing rate = $775,000 * 10% = $77,500
For short-term financing:
Permanent current assets = $350,000
Short-term financing cost = Permanent current assets * Short-term financing rate = $350,000 * 5% = $17,500
Therefore, the total interest expense is $77,500 + $17,500 = $95,000.
Now, we can calculate Lear's earnings after taxes:
Earnings before interest and taxes = $200,000
Interest expense = $95,000
Tax rate = 30%
Earnings after taxes = (Earnings before interest and taxes - Interest expense) * (1 - Tax rate)
Earnings after taxes = ($200,000 - $95,000) * (1 - 0.30) = $105,000 * 0.70 = $73,500
Therefore, Lear's earnings after taxes under this financing plan would be $73,500.
b. To calculate Lear's earnings after taxes under this alternative financing plan, we need to include the temporary current assets.
Temporary current assets = Current assets - Permanent current assets = $800,000 - $350,000 = $450,000
Total assets to be financed = Fixed assets + Permanent current assets + (0.5 * Temporary current assets) = $600,000 + $350,000 + (0.5 * $450,000) = $975,000
Long-term financing cost = Total assets to be financed * Long-term financing rate = $975,000 * 10% = $97,500
Therefore, the total interest expense is $97,500.
Now, we can calculate Lear's earnings after taxes:
Earnings before interest and taxes = $200,000
Interest expense = $97,500
Tax rate = 30%
Earnings after taxes = (Earnings before interest and taxes - Interest expense) * (1 - Tax rate)
Earnings after taxes = ($200,000 - $97,500) * (1 - 0.30) = $102,500 * 0.70 = $71,750
Therefore, Lear's earnings after taxes under this alternative financing plan would be $71,750.
c. Some risks and cost considerations associated with each alternative financing strategy include:
- Long-term financing: The main risk is the higher cost of long-term financing, as it usually has higher interest rates compared to short-term financing. This can lead to higher interest expenses, reducing earnings after taxes. Additionally, long-term financing often involves longer repayment periods, which could lead to higher total interest payments over time.
- Short-term financing: While short-term financing may have lower interest rates, it carries the risk of interest rate fluctuation. If interest rates increase in the future, the cost of short-term financing could rise significantly. Short-term financing also requires more frequent refinancing, which can incur transaction costs.
- Alternative financing plan: By including temporary current assets in the long-term financing strategy, the risk is that these assets may not be fully utilized or may not generate sufficient returns to cover the higher interest expenses. This could result in a lower level of earnings after taxes compared to the first financing plan.
It is important for Lear, Inc. to carefully consider the risks, costs, and potential benefits of each financing strategy before making a decision.