Lear Inc. has $870,000 in current assets, $385,000 of which are considered perma

Question

Lear Inc. has $870,000 in current assets, $385,000 of which are considered permanent current assets. In addition, the firm has $670,000 invested in fixed assets.    
  
a. Lear wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 8 percent. The balance will be financed with short-term financing, which currently costs 6 percent. Lear’s earnings before interest and taxes are $270,000. Determine Lear’s earnings after taxes under this financing plan. The tax rate is 40 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 and the balance with short-term financing. The same interest rates apply as in part a. Earnings before interest and taxes will be $270,000. What will be Lear’s earnings after taxes? The tax rate is 40 percent.
  

Explanation / Answer

a.

Calculation of Earnings After Tax:

Working Note:

1. Long Term Financing Cost

Fixed Assets = $ 670000

Permanent Current Assets (1/2*385000) = $ 192500

Total = $ 862500

Interest = 8% of $ 862500 = $ 69000

2. Short Term Financing Cost

Permanent Current Assets (1/2*385000) = $ 192500

Temporary Current Assets (870000-385000) = $ 485000

Total = $ 677500

Interest = 6% of $ 677500 = $ 40650

b.

Calculation of Earning After Tax

Earning Before Interest and Tax

Less: Tax @ 40%

Earning After Tax

$ 60660

$ 90990

Working Note:

1.Long Term Finance Cost

Fixed Assets = $ 670000

Permanent Current Assets = $ 385000

Temporary Current Assets ( 1/2*485000) = $ 242500

Total = $ 1297500

Interest = 8% of $ 1297500 = $ 103800

2. Short Term Finance Cost

Temporary Current Assets (1/2*485000) = $ 242500

Interest = 6% of 242500 = $ 14550

Earning Before Interest andTax $ 270000 Less: Interest on Long Term Financing $ 69000 Interest on Short Term Financing $ 40650 Earning Before Tax $ 160350 Less: Tax @ 40% $ 64140 Earning After Tax $ 96210

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