Assume that Atlas Sporting Goods Inc. has $880,000 in assets. If it goes with a

Question

Assume that Atlas Sporting Goods Inc. has $880,000 in assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 12 percent, but with a high-liquidity plan the return will be 9 percent. If the firm goes with a short-term financing plan, the financing costs on the $880,000 will be 6 percent, and with a long-term financing plan, the financing costs on the $880,000 will be 7 percent.

a. Compute the anticipated return after financing costs with the most aggressive asset-financing mix.
  

b. Compute the anticipated return after financing costs with the most conservative asset-financing mix.
  

c. Compute the anticipated return after financing costs with the two moderate approaches to the asset-financing mix.
  

d. If the firm used the most aggressive asset-financing mix described in part a and had the anticipated return you computed for part a, what would earnings per share be if the tax rate on the anticipated return was 30 percent and there were 20,000 shares outstanding? (Round your answer to 2 decimal places.)
  

e-1. Now assume the most conservative asset-financing mix described in part b will be utilized. The tax rate will be 30 percent. Also assume there will only be 5,000 shares outstanding. What will earnings per share be? (Round your answer to 2 decimal places.)
  

e-2. Would the conservative mix have higher or lower earnings per share than the aggressive mix?
  

Explanation / Answer

a. Most aggressive asset-financing mix is where we have low liquidity. The cost of financing is 7% but we'll earn 12% and the Net return is 5%. Hence, the anticipated return after financing costs for aggressive strategy is $880,000 * 5% = $44,000.

b. Most conservative asset-financing mix is where we have high liquidity. The cost of financing is 6% but we'll earn9% and the Net return is 3%. Hence, the anticipated return after financing costs for aggressive strategy is $880,000 * 3% = $26,400.

c. If we divide our assets equally in both the strategies, we'll earn 5% on $440,000 and 3% on $440,000 giving us the return amount as $35,200 (5%*440,000 + 3%*440,000).

d. Continuing with dollar return as 44,000 (5% of $880,000), paying tax @30% gives us the after tax return as $30,800 ($44,000 - $13,200). EPS is calculated as After tax profit/No. of outstanding shares

= $30,800/20,000

=$ 1.54

e-1. Our return in conservative strategy came to be $26,400. Paying tax @30% of this amount, leaves us with $18,480 ($26,400 - $7,920). Dividing this amount by 5000 shares outstanding gives us the EPS as $3.696 ($18,480/5,000).

e-2. Lower. The reason being the use of high cost of financing in the aggressive strategy than the conservative strategy. As interest costs are tax deductible, the more we use it the more we earn total profits. Also, we have earned more profits after tax while using the aggressive strategy than the conservative strategy.

Assuming same number of shares outstanding for both the strategies.

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