Question

In Problem 12, assume the term structure of interest rates becomes inverted, with short-term rates going to 11 percent and long-term rates 5 percentage points lower than short-term rates. If all other factors in the problem remain unchanged, what will earnings after taxes be?

Short answer

The earnings after taxes will be $416,400.

Step-by-step solution

Information given in the question

The following information is provided:

Long-term interest rates = 6%

Short-term interest rates =11%

Earnings before interest and taxes = $996,000

Tax rate = 40%

Calculation of interest expense

The interest expense is $302,000.

$$\begin{gathered} Interestexpense=Longterminterestexpense \\ +Shortterminterestexpense \\ =\left(\$3,200,000\times 6\%\right)+\left(\$1,000,000\times 11\%\right) \\ =\$192,000+\$110,000 \\ =\$302,000 \end{gathered}$$

Calculation of earnings after taxes

The earning after taxes is $416,400

$$\begin{gathered} Earningsaftertaxes=Earningsbeforetaxesandinterests \\ -Interestexpenses-taxes \\ =\$996,000-\$302,000-\$277,600 \\ =\$416,400 \end{gathered}$$