Question

Lake Corporation has €950,000 in current assets, out of which €425,000 are considered permanent current assets. In addition, the firm has €750,000 invested in fixed assets. The company has two financing plans under consideration:

Plan 1: Lake wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 10 percent. The balance will be financed with short-term financing, which currently costs 6 percent. Lake’s earnings before interest and taxes are €350,000. The tax rate is 40 percent.

Plan 2: As an alternative, Lake 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. Earnings before interest and taxes will be €350,000. The same tax rate and interest rates apply as in Plan 1.

Instructions:

1.     Determine Lake’s earnings after taxes under each financing plan. (10 points)
2. Which plan should Lake choose? Justify. (5 points)
3.    What are some of the risks and cost considerations associated with each of these financing plans? (5 points)

Answer 1

Solution.

1. The tax liability in the second plan is lower than of plan 1 by $2700. This is because a major portion of the debt is funded by a higher interest rate loan in Plan2. Refer to workings in the table.

2. The plan to be recommended is the Plan 1.

Reasosn:

1. It has a lower cost of interest.

2. This reduces the risk in a period where the business is not able to generate a higher EBITDA.

3. It's preferred to fund more current assets with short term loan as they are repayable immediately and they can be arranged from collections.

4. It's only justified paying a smaller interest on short term liability. Or it would be unsound financial risk management. Longer period = Higher Risk. But in this case its a shorter period.