Question

Guardian Inc. is trying to develop an asset-financing plan. The firm has $510,000 in temporary current assets and $410,000 in permanent current assets. Guardian also has $610,000 in fixed assets. Assume a tax rate of 40 percent.

a. Construct two alternative financing plans for Guardian. One of the plans should be conservative, with 90 percent of assets financed by long-term sources, and the other should be aggressive, with only 56.25 percent of assets financed by long-term sources. The current interest rate is 12 percent on long-term funds and 8 percent on short-term financing. Compute the annual interest payments under each plan.

b. Given that Guardian’s earnings before interest and taxes are $390,000, calculate earnings after taxes for each of your alternatives.

c. What would the annual interest and earnings after taxes for the conservative and aggressive strategies be if the short-term and long-term interest rates were reversed?

Answer 1

temporary current asset		510000
permanent current asset		410000
fixed assets		610000
total assets		1530000
conservative plan-90% assets with long term finance and 10% with short term finance				Amount of interest
assets financed from long term = 1530000*90%		1377000	1377000*12%	165240
assets financed from short term = 1530000*10%		153000	153000*8%	12240
total interest expense under conservative plan				177480
other plan-56.25% assets with long term finance and 43.75% with short term finance				Amount of interest
assets financed from long term = 1530000*90%	1530000*56.25%	860625	860625*12%	103275
assets financed from short term = 1530000*10%	1530000*43.75%	669375	669375*8%	53550
total interest expense under conservative plan				156825
		Conservative plan	Other plan
B-	EBIT	390000	390000
	less interest	177480	156825
	EBT	212520	233175
	less taxes-40%	85008	93270
	EAT	127512	139905
C-
conservative plan-90% assets with long term finance and 10% with short term finance				Amount of interest
assets financed from long term = 1530000*90%	1530000*90%	1377000	1377000*8%	110160
assets financed from short term = 1530000*10%	1530000*10%	153000	153000*12%	18360
total interest expense under conservative plan				128520
other plan-56.25% assets with long term finance and 43.75% with short term finance				Amount of interest
assets financed from long term = 1530000*90%	1530000*56.25%	860625	860625*8%	68850
assets financed from short term = 1530000*10%	1530000*43.75%	669375	669375*12%	80325
total interest expense under conservative plan				149175
		Conservative plan	Other plan
	EBIT	390000	390000
	less interest	128520	149175
	EBT	261480	240825
	less taxes-40%	104592	96330
	EAT	156888	144495