Problem 2 Nessie Corp. has $2,500,000 in current assets ($1,800,000 are permanen

Question

Problem 2 Nessie Corp. has $2,500,000 in current assets ($1,800,000 are permanent current assets, 700,000 are temporary current assets). The company also has $3,000,000 in fixed assets. They believe a conservative financing plan will benefit them in current economic conditions so they will use short-term financing at 7% to finance temporary current assets and they will use long-term financing at 9.5% to finance the rest. Construct a conservative financing plan. Calculate earnings after taxes. (10 points)

Explanation / Answer

Current Assets are of two types, namely: permanent and temporary.Permanent current assets are the mandatory minimum asset levels required to run the business operation. They usually comprise of inventories, accounts receivables, cash, marketable securities, cash equivalents and the like. Temporary current assets are those that occur as a result of inexplicable increment in inventory level or cash level owing to mostly seasonal variations in sales.

Permanent current assets like fixed assets are always financed using long-term debt whereas temporary current assets are financed using short-term debts.

For the problem under consideration ,

Permanent Current Assets = $1.8 m

Temporary Current Assets = $0.7 m

Fixed Assets = $3 m

Long term Financiable Assets = Permanent Current Assets + Fixed Assets = 1.8+3 = $4.8 m

Short Term Financiable Assets = Temporary Current Assets = $ 0.7 m

Therefore, Annual Interest Expense on Long-Term financing @ 9.5% = 0.095 x 4.8 = $0.456 m

Short Term Financing Expense = Annual Interest on Short-Term Loan + Short Term loan principal = 0.07 x 0.7 + 0.7 =$ 0.749 m (Assuming that short term loans are of one year maturity)

Therefore, Final Financing Plan

Long-Term Financing = $0.456 m of Yearly Interest Expense

Short-Term Financing = $0.749 m of Yearly Principal Repayment and Annual Interest Expense

Calculation of Earnings After Taxes :

Operating Profit (value not given in the problem) - Total Principal and Interest Expense = Profit Before Tax
Profit Before Tax x (1-T) = Earnings After Taxes (where T is the corporate tax rate. T=40%)

$330000-1205000 =$(875000)

Since the company faces a net operating loss, it will not be taxed at the rate of 40% and hence Earnings (rather losses) after tax would be $875000.

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