Lear inc has 800,000 in current assets, 350,000 of which areconsidered permanent

Question

Lear inc has 800,000 in current assets, 350,000 of which areconsidered permanent current assets. In addition, the firm has600,000 invested in fixed assets.

a)Lear wishes to finance all fixed assets and half of itspermanent current assets with long term financing costing 10percent. 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 financingplan. The tax rate is 30 percent.

b)As an alternative, Lear might wish to finance all fixed assetsand permanent current assets plus half of its temporary currentassets with long term financing. The same interest rates apply asin part a. Earnings before interest and taxes will be 200,000. What will be Lear’s earnings after taxes? The taxrate is 30 percent.

c)What are some of the risks and cost considerations associatedwith ach of these alternative financing strategies?

Explanation / Answer

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 andtaxes        $200,000

Interestexpense                                                               108,750

Earnings beforetaxes                                                      $ 91,250

Taxes(30%)                                                                       27,375

Earnings aftertaxes                                                         $ 63,875

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

                                                    = 5% (225,000)

                                                    = $11,250

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

                                                        + ½ ($450,000)]

                                                    = 10% ($1,175,000)

                                                    = $117,500

     Totalinterestexpense           = $11,250 + $117,500

                                                    = $128,750

     Earningsbefore interest andtaxes         $200,000

        Interest                                         128,750

     Earningsbeforetaxes                           $ 71,250

         Taxes(30%)                                 21,375

     Earningsaftertaxes                              $ 49,875

The alternative financing plan which calls for more financing byhigh-cost debt is more expensive and reduces aftertax income by$14,000. However, we must not automatically reject this planbecause of its higher cost since it has less risk. The alternativeprovides the firm with long-term capital which at times will be inexcess of its needs and invested in marketable securities. It willnot be forced to pay higher short-term rates on a large portion ofits debt when short-term rates rise and will not be faced with thepossibility of no short-term financing for a portion of itspermanent current assets when it is time to renew the short-termloan.

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