Question

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’s earnings before interest and taxes are \)240,000. Determine Lear’s 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’s 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

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

Step-by-step solution

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.

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.