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.

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

Short answer

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

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 when interest rates are reversed

The interest expense will be $135,000.

$\begin{array}{rcl}\mathit{F}\mathit{i}\mathit{n}\mathit{a}\mathit{n}\mathit{c}\mathit{i}\mathit{n}\mathit{g}\mathbf{}\mathit{P}\mathit{l}\mathit{a}\mathit{n}& \mathbf{=}& \mathit{T}\mathit{o}\mathit{t}\mathit{a}\mathit{l}\mathbf{}\mathit{a}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{\times }\mathit{A}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{}\mathit{t}\mathit{o}\mathbf{}\mathit{b}\mathit{e}\mathbf{}\mathit{f}\mathit{i}\mathit{n}\mathit{a}\mathit{n}\mathit{c}\mathit{e}\mathit{d}\mathbf{\times }\mathit{I}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathbf{}\mathit{R}\mathit{a}\mathit{t}\mathit{e}\\ & \mathbf{=}& \left(\$1,200,000\times 75\%\times 10\%\right)\mathbf{+}\left(\$1,200,000\times 25\%\times 15\%\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{90}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{45}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{\$}\mathbf{135}\mathbf{,}\mathbf{000}\end{array}$

Calculation of aggressive financing plan when interest rates are reversed

The interest expense will be $146,250.

$\begin{array}{rcl}\mathit{F}\mathit{i}\mathit{n}\mathit{a}\mathit{n}\mathit{c}\mathit{i}\mathit{n}\mathit{g}\mathbf{}\mathit{p}\mathit{l}\mathit{a}\mathit{n}& \mathbf{=}& \mathit{T}\mathit{o}\mathit{t}\mathit{a}\mathit{l}\mathbf{}\mathit{a}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{\times }\mathit{A}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathit{s}\mathbf{}\mathit{t}\mathit{o}\mathbf{}\mathit{b}\mathit{e}\mathbf{}\mathit{f}\mathit{i}\mathit{n}\mathit{a}\mathit{n}\mathit{c}\mathit{e}\mathit{d}\mathbf{\times }\mathit{I}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathbf{}\mathit{r}\mathit{a}\mathit{t}\mathit{e}\\ & \mathbf{=}& \left(\$1,200,000\times 56.25\%\times 10\%\right)\mathbf{+}\left(\$1,200,000\times 56.25\%\times 10\%\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{67}\mathbf{,}\mathbf{500}\mathbf{+}\mathbf{\$}\mathbf{78}\mathbf{,}\mathbf{750}\\ & \mathbf{=}& \mathbf{\$}\mathbf{146}\mathbf{,}\mathbf{250}\end{array}$

Calculation of earnings after taxes

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

$\begin{array}{rcl}\mathit{E}\mathit{a}\mathit{r}\mathit{n}\mathit{i}\mathit{n}\mathit{g}\mathit{s}\mathbf{}\mathit{a}\mathit{f}\mathit{t}\mathit{e}\mathit{r}\mathbf{}\mathit{t}\mathit{a}\mathit{x}\mathit{e}\mathit{s}& \mathbf{=}& \mathit{E}\mathit{a}\mathit{r}\mathit{n}\mathit{i}\mathit{n}\mathit{g}\mathit{s}\mathbf{}\mathit{b}\mathit{e}\mathit{f}\mathit{o}\mathit{r}\mathit{e}\mathbf{}\mathit{i}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathbf{}\mathit{a}\mathit{n}\mathit{d}\mathbf{}\mathit{t}\mathit{a}\mathit{x}\mathit{e}\mathit{s}\mathbf{-}\mathit{I}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathbf{}\mathit{E}\mathit{x}\mathit{p}\mathit{e}\mathit{n}\mathit{s}\mathit{e}\mathit{s}\mathbf{-}\mathit{T}\mathit{a}\mathit{x}\mathit{e}\mathit{s}\\ & \mathbf{=}& \mathbf{\$}\mathbf{200}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{135}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{26}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{\$}\mathbf{39}\mathbf{,}\mathbf{000}\end{array}$

$\begin{array}{rcl}\mathit{E}\mathit{a}\mathit{r}\mathit{n}\mathit{i}\mathit{n}\mathit{g}\mathit{s}\mathbf{}\mathit{a}\mathit{f}\mathit{t}\mathit{e}\mathit{r}\mathbf{}\mathit{t}\mathit{a}\mathit{x}\mathit{e}\mathit{s}& \mathbf{=}& \mathit{E}\mathit{a}\mathit{r}\mathit{n}\mathit{i}\mathit{n}\mathit{g}\mathit{s}\mathbf{}\mathit{b}\mathit{e}\mathit{f}\mathit{o}\mathit{r}\mathit{e}\mathbf{}\mathit{i}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathbf{}\mathit{a}\mathit{n}\mathit{d}\mathbf{}\mathit{t}\mathit{a}\mathit{x}\mathit{e}\mathit{s}\mathbf{-}\mathit{I}\mathit{n}\mathit{t}\mathit{e}\mathit{r}\mathit{e}\mathit{s}\mathit{t}\mathbf{}\mathit{E}\mathit{x}\mathit{p}\mathit{e}\mathit{n}\mathit{s}\mathit{e}\mathit{s}\mathbf{-}\mathit{T}\mathit{a}\mathit{x}\mathit{e}\mathit{s}\\ & \mathbf{=}& \mathbf{\$}\mathbf{200}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{146}\mathbf{,}\mathbf{250}\mathbf{-}\mathbf{\$}\mathbf{21}\mathbf{,}\mathbf{500}\\ & \mathbf{=}& \mathbf{\$}\mathbf{32}\mathbf{,}\mathbf{250}\end{array}$