Question

Guardian Inc. is trying to develop an asset-financing plan. The firm has $470,000 in temporary current assets and $370,000 in permanent current assets. Guardian also has $570,000 in fixed assets. Assume a tax rate of 30 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 16 percent on long-term funds and 9 percent on short-term financing. Compute the annual interest payments under each plan.

	Annual Interest Conservative Aggressive

  

   

b. Given that Guardian’s earnings before interest and taxes are $350,000, calculate earnings after taxes for each of your alternatives.
  

	Earning After Taxes 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?
  

	Conservative Aggressive Total interest Earnings after taxes

Answer 1

a) Constructing Two alternative financing plans for Guardian and Computing the Interest Payments under each Plan:

Guardian, Inc.
Temporary Current Assets	$470,000
Permanent Current Assets	$370,000
Fixed Assets	$570,000
Total Assets	$1,410,000

Conservative Plan:

Amount	% of Total	Interest Rate	Interest Expense
$1,410,000 * 90%	$1,269,000	16%	$203040
$1,410,000 * 10%	$141,000	9%	$12690
Total Interest Expense			$215,730

Aggressive Plan:

Amount	% of Total	Interest Rate	Interest Expense
$1,410,000 * 56.25%	$793,125	16%	$126,900
$1,410,000 * 43.75%	$616,875	9%	$55519
Total Interest Expense			$182,419

b) Calculation of the Earnings After Taxes for each of your alternatives:

Particulars	Conservative	Aggressive
EBIT	$350,000	$350,000
Less: Interest	$215,730	$182,419
EBT	$134,270	$167,581
Tax (30%)	$40,281	$50,274
EAT	$93989	$117307

c) Calculation of the Annual Interest Charges and Earnings After Taxes for the Conservative and Aggressive Stratagies be if Short-term adn Long-term Interest rates were reversed:

Conservative Plan:

Amount	% of Total	Interest Rate	Interest Expense
$1,410,000 * 90%	$1,269,000	9%	$114,210
$1,410,000 * 10%	$141,000	16%	$22,560
Total Interest Expense			$136,770

Aggressive Plan:

Amount	% of Total	Interest Rate	Interest Expense
$1,410,000 * 56.25%	$793,125	9%	$71,381
$1,410,000 * 43.75%	$616,875	16%	$98,700
Total Interest Expense			$170,081

Particulars	Conservative	Aggressive
EBIT	$350,000	$350,000
Less: Interest	$136,770	$170,081
EBT	$213,230	$179,919
Tax (30%)	$63,969	$53,976
EAT	$149,261	$125,943