Question

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.

a. Construct two alternative financing plans for Guardian. One of the plans should be conservative, with 75 percent of assets financed by long-term sources, and the other should be aggressive, with only 56.25 percent of assets financed by long-term sources. The current interest rate is 15 percent on long-term funds and 10 percent on short-term financing.

Short answer

The interest expense in the conservative approach will be $165,000 and $153,750 in the aggressive approach.

Step-by-step solution

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%

Calculation of conservative financing plan:

The interest expense will be $165,000.

$\begin{array}{rcl}\mathit{F}\mathit{i}\mathit{n}\mathit{a}\mathit{n}\mathit{c}\mathit{i}\mathit{n}\mathit{g}\mathbf{}\mathit{p}\mathit{l}\mathit{a}\mathit{n}& \mathbf{=}& \mathit{T}\mathit{o}\mathit{t}\mathit{a}\mathit{l}\mathbf{}\mathit{a}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{\times }\mathit{A}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{}\mathit{t}\mathit{o}\mathbf{}\mathit{b}\mathit{e}\mathbf{}\mathit{f}\mathit{i}\mathit{n}\mathit{a}\mathit{n}\mathit{c}\mathit{e}\mathit{d}\mathbf{\times }\mathit{I}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathbf{}\mathit{r}\mathit{a}\mathit{t}\mathit{e}\\ & \mathbf{=}& \mathbf{(}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{75}\mathbf{\%}\mathbf{\times }\mathbf{15}\mathbf{\%}\mathbf{)}\mathbf{+}\mathbf{(}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{25}\mathbf{\%}\mathbf{\times }\mathbf{10}\mathbf{\%}\mathbf{)}\\ & \mathbf{=}& \mathbf{\$}\mathbf{135}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{30}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{\$}\mathbf{165}\mathbf{,}\mathbf{000}\end{array}$

Calculation of aggressive financing plan:

The interest expense will be $153,750.

$\begin{array}{rcl}\mathit{F}\mathit{i}\mathit{n}\mathit{a}\mathit{n}\mathit{c}\mathit{i}\mathit{n}\mathit{g}\mathbf{}\mathit{p}\mathit{l}\mathit{a}\mathit{n}& \mathbf{=}& \mathit{T}\mathit{o}\mathit{t}\mathit{a}\mathit{l}\mathbf{}\mathit{a}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{\times }\mathit{A}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{}\mathit{t}\mathit{o}\mathbf{}\mathit{b}\mathit{e}\mathbf{}\mathit{f}\mathit{i}\mathit{n}\mathit{a}\mathit{n}\mathit{c}\mathit{e}\mathit{d}\mathbf{\times }\mathit{I}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathbf{}\mathit{r}\mathit{a}\mathit{t}\mathit{e}\\ & \mathbf{=}& \left(\$1,200,000\times 56.25\%\times 15\%\right)\mathbf{+}\left(\$1,200,000\times 43.75\%\times 10\%\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{101}\mathbf{,}\mathbf{250}\mathbf{+}\mathbf{\$}\mathbf{52}\mathbf{,}\mathbf{500}\\ & \mathbf{=}& \mathbf{\$}\mathbf{153}\mathbf{,}\mathbf{750}\end{array}$