Alternative Financing Plans Essay Example
Complete Problem 14 on p. 184.
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.
Answer: Earnings after taxes is $23,875
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.
Answer: Earnings after taxes is $49,875
c. What are some of the risks and cost considerations associated with each of these alternative financing strategies? Answer: Short term rates are more volatile than long term. Volatility is what makes a short-term financing strategy risky. In the first plan, short term financing is covering more than long term. While short term rates are usually less than the rates of long term loans, the rates can fluctuate erratically. As inflation goes up or down, so do interest rates. If this happens, then unexpected rate hikes can mean less earnings or even bankruptcy. Since it is cheaper to issue long-term capital in large sums, the disadvantage is the total needs are not totally predictable and the financing tends to be out of sync with the actual needs. This cost wise may increase costs due to the need of short term loans in addition to make up for any shortfalls.
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.
Answer: Earnings after taxes is $23,875
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.
Answer: Earnings after taxes is $49,875
c. What are some of the risks and cost considerations associated with each of these alternative financing strategies? Answer: Short term rates are more volatile than long term. Volatility is what makes a short-term financing strategy risky. In the first plan, short term financing is covering more than long term. While short term rates are usually less than the rates of long term loans, the rates can fluctuate erratically. As inflation goes up or down, so do interest rates. If this happens, then unexpected rate hikes can mean less earnings or even bankruptcy. Since it is cheaper to issue long-term capital in large sums, the disadvantage is the total needs are not totally predictable and the financing tends to be out of sync with the actual needs. This cost wise may increase costs due to the need of short term loans in addition to make up for any shortfalls.