Alternative Financing

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.
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.
- All fixed assets= $600,000
- Half of its permanent current assets = $175,000
- Long-term financing cost= 10%
- Earnings before interest and taxes = $200,000
- Tax rate= 30%

Long-term interest cost = $775,000 x 10% = $77,500
Short-term interest expense= $625,000 x 5% = $31,250
Total interest cost = $31,250 +$77,500 = $108,750
Earnings before interest and taxes = $200,000 - $108,750 = $91,250
Earnings after taxes = $91,250 – 30% = $91,250 - $27,375= $63,875

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.
All Fixed Assets= $600,000
Permanent current assets = $350,000
Half of temporary current assets = $225,000
Long-term Financing cost= 10%
Earnings before interest and taxes= $200,000
Tax rate= 30%

Long-term interest cost= $1,175,000 x 10% = $117,500
Short-term interest expense= $225,000 x 5% = $11,250
Total interest cost= $117,500 + $11,250 = $128,750
Earnings before interest and taxes= $200,000 - $128,750= $71,250
Earnings after taxes = $71,250 – 30%= $71,250 - $21,375= $49,875

c. What are some of the risks and cost considerations associated with each of these alternative financing strategies?
No matter which financing plan the company chooses, there are risks and