Guardian inc is trying to develop an asset financing plan . The firm has $400,00

Question

Guardian inc is trying to develop an asset financing plan . The firm has $400,000 in temporary current assets and $300,000 in permanent current assets. Guardian also has $500,000 in fixed assets. Assume a tax rate of 40%. Construct two alternative financing plans for guardian. One should be conservative with 75% of assets financed by long term sources and the other should be aggressive with only 56.25% of assets financed by long term sources. The current interest rate is 15% on long term funds and 10% on short term financing. Please show your work. B. Given that guardians earnings before interest and taxes are $200,000, calculate earnings after taxes for each of your alternatives. C. What would happen if the short term and long term rates were reversed? Please show work.

Explanation / Answer

Answer A:

Total Assets = $400000 + $300000 + $500000 = $ 1200000

Financing Plan 1: 75% Long term Financing

75% of 1200000 = $ 900000 from Long term Finance

i.e. $300000 from Short term Finance

Interest Cost = 15% of 900000 + 10% of 300000 = $ 165000

Financing Plan 2 : 56.25 % Long term Financing

56.25 % of 1200000 = $ 675000 from Long term finance

$ 525000 from Short term finance

Interest Cost = 15% of 675000 + 10% of 525000 = 101250 + 52500 = 153750

Answer B:

EBIT = $200000

Earnings after Interest:

Under financing plan 1 = 200000-165000 = 35000

Under financing plan 2 = 200000-153750 = 46250

Taxes:

Under Financing Plan 1 = 35000* 40% = 14000

Under Financing Plan 2 = 46250* 40% = 18500

Earnings after taxes

Under Financing Plan 1 = 35000-14000 = $ 21000

Under Financing plan 2 = 46250-18500 = $ 27750

Answer C:

If Short term and long term rate are reversed interest cost equals

Interest cost:

Under Financing Plan 1: 10% of 900000 + 15% of 300000 = 135000

Under Financing Plan 2:10% of 675000 + 15% of 525000 = 146250

Earnings after Interest:

Under Financing Plan 1: $200000-135000 = 65000

Under Financing Plan 2: $200000-146250 = 53750

Taxes:

Under Financing Plan 1: 40% of 65000= 26000

Under Financing Plan 2: 40% of 53750=21500

Earnings after Interest and taxes:

Under Financing Plan 1: $65000-26000 = 39000

Under Financing Plan 2: $53750-21500 = 32250

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