(2) Christensen & Assoc. is developing an asset financing plan. Christensen has
ID: 2666241 • Letter: #
Question
(2) Christensen & Assoc. is developing an asset financing plan. Christensen has $500,000 in current assets, of which 15% are permanent, and $700,000 in fixed assets. The current long-term rate is 11%, and the current short-term rate is 8.5%. Christensen's tax rate is 40%.a) Construct two financing plans--one conservative, with 80% of assets financed by long-term sources, and the other aggressive, with only 60% of assets financed by long-term sources.
b) If Christensen's earnings before interest and taxes are $325,000, calculate net income under each alternative.
c) What are some of the risks associated with each plan?
d) Which plan would you recommend to Christensen? Why?
Explanation / Answer
a) Plan 1 - 80% Financed by long term sources: Total Investment = 1200000 80% Assets = 1200000*80% = 960000 Long term Interest Rate = 11% Interest amount for 80% investment = 960000 * 11% = $105,600 Interest on 20% Investment = 240000 * 8.5% = $20,400 Total Interest Expence per year(105600 + 20400) = $126,000 Plan 2 - 60% Financed by long term sources: Total Investment = 1200000 60% of Assets = 1200000*60% = 720000 Long term Interest Rate = 11% Interest amount for 60% investment = 720000 * 11% = $79,200 Interest on 40% Investment = 480000 * 8.5% = $40,800 Total Interest expense per year(79200 + 40800) = $120,000 b) Plan - 1 Income Before Interest & Tax 325000 Interest as per plan - 1 126000 Income after interest 199000 Tax (199000 * 40%) 79600 Net Income 119400 Plan - 2 Income Before Interest & Tax 325000 Interest as per plan - 1 120000 Income after interest 205000 Tax (205000 * 40%) 82000 Net Income 123000 Excess Net Income from plan 2(123000 - 119400) 3600 Plan - 1 Income Before Interest & Tax 325000 Interest as per plan - 1 126000 Income after interest 199000 Tax (199000 * 40%) 79600 Net Income 119400 Plan - 2 Income Before Interest & Tax 325000 Interest as per plan - 1 120000 Income after interest 205000 Tax (205000 * 40%) 82000 Net Income 123000 Excess Net Income from plan 2(123000 - 119400) 3600c) If we select 1 plan we have to loose $3,600 net income every year.Because interest rate is higher than second plan. If we choose second plan we can get additional $3,600 net income. But we have to search in different markets for loan every year, because it is not a fixed loan. d) I want to select Second Plan, because it is giving additional profit of $3,600, we have to search short term loan for 40% of investment if we select first plan also. If we select second plan we have to gather 60% of short term loan, it means we have to search for additional 20% loan only. We can get this 20% loan in markets easily. Thank you..... Plan 1 - 80% Financed by long term sources: Total Investment = 1200000 80% Assets = 1200000*80% = 960000 Long term Interest Rate = 11% Interest amount for 80% investment = 960000 * 11% = $105,600 Interest on 20% Investment = 240000 * 8.5% = $20,400 Total Interest Expence per year(105600 + 20400) = $126,000 Plan 2 - 60% Financed by long term sources: Total Investment = 1200000 60% of Assets = 1200000*60% = 720000 Long term Interest Rate = 11% Interest amount for 60% investment = 720000 * 11% = $79,200 Interest on 40% Investment = 480000 * 8.5% = $40,800 Total Interest expense per year(79200 + 40800) = $120,000
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