Alternative Financing Plans
ALTERNATIVE FINANCING PLANS
Current assets – permanent current assets = temporary current assets
$800,000 – $350,000 = $450,000
Short-term interest expense = 5% [$450,000 + ½ ($350,000)]
= 5% ($625,000)
= $31,250
Long-term interest expense = 10% [$600,000 + ½ ($350,000)]
= 10% ($775,000)
= $77,500
Total interest expense = $31,250 + $77,500
= $108,750
Earnings before interest and taxes $200,000
Interest expense 108,750
Earnings before taxes $ 91,250
Taxes (30%) 27,375
Earnings after taxes $ 63,875
b. Alternative financing plan
Short-term interest expense = 5% [½ ($450,000)]
= 5% (225,000)
= $11,250
Long-term interest expense = 10% [$600,000 + $350,000
+ ½ ($450,000)]
= 10% ($1,175,000)
= $117,500
Total interest expense = $11,250 + $117,500
= $128,750
Earnings before interest and taxes $200,000
Interest 128,750
Earnings before taxes $ 71,250
Taxes (30%) 21,375
Earnings after taxes $ 49,875
c. The alternative financing plan which calls for more financing by high-cost debt is more expensive and reduces aftertax income by $14,000. However, we must not automatically reject this plan because of its higher cost since it has less risk. The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities. It will not be forced to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the short-term
Current assets – permanent current assets = temporary current assets
$800,000 – $350,000 = $450,000
Short-term interest expense = 5% [$450,000 + ½ ($350,000)]
= 5% ($625,000)
= $31,250
Long-term interest expense = 10% [$600,000 + ½ ($350,000)]
= 10% ($775,000)
= $77,500
Total interest expense = $31,250 + $77,500
= $108,750
Earnings before interest and taxes $200,000
Interest expense 108,750
Earnings before taxes $ 91,250
Taxes (30%) 27,375
Earnings after taxes $ 63,875
b. Alternative financing plan
Short-term interest expense = 5% [½ ($450,000)]
= 5% (225,000)
= $11,250
Long-term interest expense = 10% [$600,000 + $350,000
+ ½ ($450,000)]
= 10% ($1,175,000)
= $117,500
Total interest expense = $11,250 + $117,500
= $128,750
Earnings before interest and taxes $200,000
Interest 128,750
Earnings before taxes $ 71,250
Taxes (30%) 21,375
Earnings after taxes $ 49,875
c. The alternative financing plan which calls for more financing by high-cost debt is more expensive and reduces aftertax income by $14,000. However, we must not automatically reject this plan because of its higher cost since it has less risk. The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities. It will not be forced to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the short-term