Lear, Inc. has $800,000 in current assets, $350,000 of which are considered permanent current assets. In addition, the firm has $600,000 invested in fixed assets. a. Lear wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 10 percent. Short-term financing currently costs 5 percent. Lear’s earnings before interest and taxes are $200,000. Determine Lear’s earnings after taxes under this financing plan. The tax rate is 30 percent.
$175,000(half of working capital)+$600,000(fixed assets)=$775,000 in assets to be financed with LT Debt (10% interest rate) The other $175,000(half of permanent current) will be financed at 5% as well as the $450,000 in variable current assets. ($625,000x.05) EBIT: $200,000
LT Expense: $77,500
ST Expense: $31,250
Taxes (30%): $27,375
Net Income: $63,875
b. As an alternative, Lear might wish to finance all fixed assets and permanent current assets plus half of its temporary current assets with long-term financing. The same interest rates apply as in part a. Earnings before interest and taxes will be $200,000. What will be Lear’s earnings after taxes? The tax rate is 30 percent. $225,000(half of variable current assets)+$350,000(permanent current)+$600,000(all fixed)=$1,175,000 borrowed at 10% EBIT: $200,000
LT Expense: $117,500
ST Expense: $11,250
Tax (30%): $21,375
Net Income: $49,875
c. What are some of the risks and cost considerations associated with each of these alternative financing strategies? Using long-term financing to finance part of temporary current assets, a firm may have less risk but lower returns than a firm with a normal financing plan. By establishing a long-term financing arrangement for temporary current assets, a firm is...