Question

Guardian Inc. is trying to develop an asset-financing plan. The firm has $380,000 in temporary current assets and $280,000 in permanent current assets. Guardian also has $480,000 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 80 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 6 percent on short-term financing. Compute the annual interest payments under each plan.
  

   

b. Given that Guardian’s earnings before interest and taxes are $260,000, 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

		Conservative Plan	Aggressive Plan
	Temporary current assets	380000	380000
	Permanent current assets	280000	280000
	Fixed assets	480000	480000
	Total Assets	1140000	1140000
a	Long term finance	912000	641250
	Short term finance	228000	498750
	Interest on long term finance	109440	76950
	Interest on short term finance	13680	29925
	Total interest	123120	106875
b	EBIT	260000	260000
	Interest	123120	106875
	Profit before tax	136880	153125
	Less: Tax	41064	45937.5
	Profit after tax	95816	107187.5

c After Reversal
	Conservative Plan	Aggressive Plan
Total Assets	480000	480000
Long term finance	384000	270000
Short term finance	96000	210000
Interest on long term finance	23040	16200
Interest on short term finance	11520	25200
Total interest	34560	41400
EBIT	260000	260000
Interest	34560	41400
Profit before tax	225440	218600
Less: Tax	67632	65580
Profit after tax	157808	153020

WORKINGS