Alternative Financing Plans

ALTERNATIVE FINANCING PLANS

Current assets – permanent current assets = temporary current assets

$800,000 – $350,000 = $450,000

Short-term interest expense = 5% [$450,000 + ½ ($350,000)]

= 5% ($625,000)

= $31,250

Long-term interest expense = 10% [$600,000 + ½ ($350,000)]

= 10% ($775,000)

= $77,500

Total interest expense = $31,250 + $77,500

= $108,750

Earnings before interest and taxes $200,000

Interest expense 108,750

Earnings before taxes $ 91,250

Taxes (30%) 27,375

Earnings after taxes $ 63,875
b. Alternative financing plan

Short-term interest expense = 5% [½ ($450,000)]

= 5% (225,000)

= $11,250

Long-term interest expense = 10% [$600,000 + $350,000

+ ½ ($450,000)]

= 10% ($1,175,000)

= $117,500

Total interest expense = $11,250 + $117,500

= $128,750

Earnings before interest and taxes $200,000

Interest 128,750

Earnings before taxes $ 71,250
Taxes (30%) 21,375

Earnings after taxes $ 49,875
c. The alternative financing plan which calls for more financing by high-cost debt is more expensive and reduces aftertax income by $14,000. However, we must not automatically reject this plan because of its higher cost since it has less risk. The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities. It will not be forced to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the short-term