Question

CHAPTER 6

Sharpe Knife Company expects sales next year to be $1,650,000 if the economy is strong, $875,000 if the economy is steady, and $650,000 if the economy is weak. Mr. Sharpe believes there is a 10 percent probability the economy will be strong, a 45 percent probability of a steady economy, and a 45 percent probability of a weak economy

What is the expected level of sales for the next year?

EXPECTED LEVEL OF SALES =

Guardian Inc. is trying to develop an asset-financing plan. The firm has $310,000 in temporary current assets and $210,000 in permanent current assets. Guardian also has $410,000 in fixed assets. Assume a tax rate of 20 percent.

a. Construct two alternative financing plans for Guardian. One of the plans should be conservative, with 60 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 5 percent on short-term financing. Compute the annual interest payments under each plan.
CONSERVATIVE =

AGGRESSIVE =

b. Given that Guardian’s earnings before interest and taxes are $190,000, calculate earnings after taxes for each of your alternatives.
CONSERVATIVE=

AGGRESSIVE =

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?
TOTAL INTEREST =

EARNINGS AFTER TAXES =

Answer 1

1.

Expected level of sale next year = ($1,650,000  × 10%) + ($875,000 × 45%) + ($650,000 × 45%)

= $165,000 + $393,750 + $292,500

= $851,250

Expected level of sale next year will be $851,250.

2.

Value of total Assets = Temporary Current Assets + Permanent Current Assets + Fixed Assists

                                     = $310,000 + $210,000 + $410,000

                                     = $930,000

Value of total assets is $930,000.

a.

Under conservative alternative 60% of assets finance with long term debt and 40% with short term debt.

So,

Value of long term debt = $930,000 × 60%

                                            = $558,000

Value of long term debt is $558,000.

Value of short term debt = $930,000 - $558,000

                                              = $372,000

Value of short term debt is $372,000.

current interest rate is 12 percent on long-term funds and 5 percent on short-term financing

So, total interest expense = ($558,000 × 12%) + ($372,000 × 5%)

                                               = $66,960 + $18,600

                                               = $85,560.

Total Interest Expense Under conservative alternative is $85,560.

Again,

Under Aggressive alternative 56.25% of assets finance with long term debt and 43.75% with short term debt.

So,

Value of long term debt = $930,000 × 56.25%

                                            = $523,125

Value of long term debt is $523,125

Value of short term debt = $930,000 - $523,125

                                              = $406,875

Value of short term debt is $406,875

current interest rate is 12 percent on long-term funds and 5 percent on short-term financing

So, total interest expense = ($523,125 × 12%) + ($406,875 × 5%)

                                               = $62,775 + $20,343.75

                                               = $83,118.75.

Total Interest Expense Under aggressive alternative is $83,118.75.

b.

EBIT = $190,000

Profit after tax under conservative alternative = ($190,000 - $85,560) × (1 – 20%)

                                                                                    = $104,440 × 80%

                                                                                    = $83,552

Profit after tax under conservative alternative is $83,552.

Again,

Profit after tax under Aggrressive alternative = ($190,000 - $83,118.75) × (1 – 20%)

                                                                                    = $106,881.25 × 80%

                                                                                    = $85,505

Profit after tax under Aggressive alternative is $85,505

c.

if the short-term and long-term interest rates were reversed then

Total interest expense under conservative approach

total interest expense = ($558,000 × 5%) + ($372,000 × 12%)

                                         = $27,900 + $44,640

                                        = $72,540

Total interest expense under conservative approach become $72,540.

Now,

Profit after tax under conservative alternative = ($190,000 - $72,540) × (1 – 20%)

                                                                                    = $117,460 × 80%

                                                                                    = $93,968

Profit after tax under conservative alternative is $93,968.

Again,

Total interest expense under aggressive approach

total interest expense = ($523,125 × 12%) + ($406,875 × 5%)

                                          = $26,156.25 + $48,825

                                          = $74,981.25.

Total interest expense under aggressive approach become $74,981.25

Now,

Profit after tax under aggressive alternative = ($190,000 - $74,981.25) × (1 – 20%)

                                                                                    = $115,018.75 × 80%

                                                                                    = $92,015

Profit after tax under aggressive alternative is $92,015.