Hello Kitty Kat House is developing an asset financing plan. Kitty has $500,000
ID: 2822884 • Letter: H
Question
Hello Kitty Kat House is developing an asset financing plan. Kitty 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%. Kitty's tax rate is 40%.
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.
If Kitty's earnings before interest and taxes are $325,000, calculate net income under each alternative.
A. A) Plan A $123,000 Plan B $119,000
B. B) Plan A $132,000 Plan B $123,500
C. C) Plan A $19,000 Plan B $26,000
D. D) Plan A $119,000 Plan B $123,000
Explanation / Answer
Total Assets = Fixed Assets + Current Assets = 500,000 + 700,000 = 1,200,000
Conservative Plan - Plan A
80% Long term financing and 20% short term financing
Interest expense for long term financing = 80% * 1,200,000 * 11% = 105,600
Interest expense for short term financing = 20% * 1,200,000 * 8.5% = 20,400
Net Income = [EBIT - Interest Expense] * (1 - Tax rate)
Net Income = [325,000 - 126000] * (1 - 40%) = 119,400
Aggressive Plan - Plan B
60% Long term financing and 40% short term financing
Interest expense for long term financing = 60% * 1,200,000 * 11% = 79200
Interest expense for short term financing = 40% * 1,200,000 * 8.5% = 40800
Net Income = [EBIT - Interest Expense] * (1 - Tax rate)
Net Income = [325,000 - 120000] * (1 - 40%) = 123,000
Hence, Option D is the closest and that is the answer
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