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Chapter 3: Q14BP_c (page 157)

Guardian Inc. is trying to develop an asset financing plan. The firm has \(400,000 in temporary current assets and \)300,000 in permanent current assets. Guardian also has $500,000 in fixed assets. Assume a tax rate of 40 percent.

c. What would happen if the short- and long-term rates were reversed?

Short Answer

Expert verified

When the rates are reversed, the interest expense will be $135,000, and earnings after tax will be $39,000. In the aggressive approach, the interest expense will be $146,250, and the earnings after tax will be $32,250.

Step by step solution

01

Information given in the question

The following information is provided:

Temporary current assets =$400,000

Permanent current assets =$300,000

Fixed assets =$500,000

Total assets =$1,200,000

Tax rate = 40%

02

Calculation of conservative financing plan when interest rates are reversed

The interest expense will be $135,000.

FinancingPlan=Totalassets脳Assetstobefinanced脳InterestRate=($1,200,000脳75%脳10%)+($1,200,000脳25%脳15%)=$90,000+$45,000=$135,000

03

Calculation of aggressive financing plan when interest rates are reversed

The interest expense will be $146,250.

Financingplan=Totalassets脳Assetstobefinanced脳Interestrate=($1,200,000脳56.25%脳10%)+($1,200,000脳56.25%脳10%)=$67,500+$78,750=$146,250

04

Calculation of earnings after taxes

The earnings after taxes will be $39,000 in the conservative approach and $32,250 in the aggressive approach.

Earningsaftertaxes=Earningsbeforeinterestandtaxes-InterestExpenses-Taxes=$200,000-$135,000-$26,000=$39,000

Earningsaftertaxes=Earningsbeforeinterestandtaxes-InterestExpenses-Taxes=$200,000-$146,250-$21,500=$32,250

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Most popular questions from this chapter

鈥淭he most appropriate financing pattern would be one in which asset build-up and length of financing terms are perfectly matched.鈥� Discuss the difficulty involved in achieving this financing pattern.

Assume that Atlas Sporting Goods Inc. has \(840,000 in assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 15 percent, but with a high-liquidity plan the return will be 12 percent. If the firm goes with a short-term financing plan, the financing costs on the \)840,000 will be 9 percent, and with a long-term financing plan, the financing costs on the $840,000 will be 11 percent. (Review Table 6-11 for parts a, b, and c of this problem.)

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?

e. 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? Would it be higher or lower than the earnings per share computed for the most aggressive plan computed in part d?

What does the term structure of interest rates indicate?

Carey Company is borrowing $200,000 for one year at 12 percent from Second Intrastate Bank. The bank requires a 20 percent compensating balance. What is the effective rate of interest? What would the effective rate be if Carey were required to make 12 equal monthly payments to retire the loan? The principal, as used in Formula 8-6, refers to funds the firm can effectively utilize (Amount borrowed - Compensating balance).

Route Canal Shipping Company has the following schedule for aging of accounts receivable:

b. If the firm had $1,500,000 in credit sales over the four-month period, compute the average collection period. Average daily sales should be based on a 120-day period.
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