Question

Currently, Atlas Tours has $6.76 million in assets. This is a peak six-month period. During the other six months, temporary current assets drop to $570,000.

  

Temporary current assets	$1,370,000
Permanent current assets	2,140,000
Capital assets	3,250,000
Total assets	$6,760,000

  

Short-term rates are 5 percent. Long-term rates are 7 percent. Annual earnings before interest and taxes are $1,250,000. The tax rate is 38 percent.

a. If the assets are perfectly hedged throughout the year, what will earnings after taxes be? (Enter answers in whole dollar, not in million.)

Earnings after taxes            $

b. If short-term interest rates increase to 7 percent when assets are at their lowest level, what will earnings after taxes be? For an example of perfectly hedged plans, see Figure 6–8

  

Earnings after taxes            $

Answer 1

a) Given that:

Long term financing = Permanent current assets + capital assets

= 2,140,000 + $3,250,000

= $5,390,000

Short- term financing = Temporary current assets ( six months) + Temporary current assets ( other six months)

= $1,370,000 + $570,000

= $1,940,000

Total interest expense = Long term interest expense + short term interest expense

= ( Long term financing * long term rates) + ( short term financing * short term rates)

= ( $5,390,000*0.07) + ( $1,940,000*0.05)

= $377,300 + $97,000

= $474,300

Net income = ( Earning before interest and tax - interest expense) * (1-tax rate)

=  ($1,250,000 - $474,300 ) * ( 1 - 0.38)

=$775700 * 0.62

= $480,934

b) Total interest expense = Long term interest expense + Short term interest expense

= ($5,390,000*0.07) + ($$1,370,000*0.0.05) + ($570,000*0.07)

= $377,300 + $68,500 + $39,900

= $485,700

Net income = ( Earning before interest and tax - interest expense) * (1-tax rate)

= $1,250,000 - $485,700) * (1-0.38)

= $764,300 * 0.62

= $473,866