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Chapter 3: Q15BP_c (page 187)

Lear Inc. has \(840,000 in current assets, \)370,000 of which are considered permanent current assets. In addition, the firm has \(640,000 invested in fixed assets.

a. Lear wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 8 percent. The balance will be financed with short-term financing, which currently costs 7 percent. Lear鈥檚 earnings before interest and taxes are \)240,000. Determine Lear鈥檚 earnings after taxes under this financing plan. The tax rate is 30 percent.

b. As an alternative, Lear might wish to finance all fixed assets and permanent current assets plus half of its temporary current assets with long-term financing and the balance with short-term financing. The same interest rates apply as in part a. Earnings before interest and taxes will be $240,000. What will be Lear鈥檚 earnings after taxes? The tax rate is 30 percent.

c. What are some of the risks and cost considerations associated with each of these alternative financing strategies?

Short Answer

Expert verified

The alternative plan will decrease the earnings after tax by $2,940 and carry a lower risk.

Step by step solution

01

Factors to consider when selecting the financing strategy

The organization should consider the following factors when selecting the financing strategy:

  • The amount of finance required by the organization.
  • The period of finance, i.e., long-term or short-term financing.
  • The risk involved in the financing strategy.
  • The cost of financing to the organization.
02

Explanation for requirement (c)

The alternative financing option is costlier and lowers the after-tax income by $2,940, but this plan has less risk. This plan will provide the organization with long-term finance, which will allow the organization to invest the excess finance in marketable securities. This will also help the organization pay high short-term interest rates and face the non-availability of short-term finance when required.

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Most popular questions from this chapter

Using the expectations hypothesis theory for the term structure of interest rates, determine the expected return for securities with maturities of two, three, and four years based on the following data. Do an analysis similar to that in the right-hand portion of Table 6-6.

1-year T bill at the beginning of year 1

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1-year T bill at the beginning of year 2

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1-year T bill at the beginning of year 3

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1-year T bill at the beginning of year 4

10%

Discuss the relative volatility of short- and long-term interest rates

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Bambino Sporting Goods makes baseball gloves that are very popular in the spring and early summer season. Units sold are anticipated as follows:

March

3,250

April

7,250

May

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June

9,500

Total units

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If seasonal production is used, it is assumed that inventory will directly match sales for each month and there will be no inventory build-up. The production manager thinks the preceding assumption is too optimistic and decides to go with level production to avoid being out of merchandise. He will produce the 31,500 units over four months at a level of 7,875 per month.

a. What is the ending inventory at the end of each month? Compare the unit sales to the units produced and keep a running total.

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