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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

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

Oral Roberts Dental Supplies has annual sales of \(5,200,000. Ninety percent are on credit. The firm has \)559,000 in accounts receivable. Compute the value of the average collection period.

“The most appropriate financing pattern would be one in which asset build-up and length of financing terms are perfectly matched.” Discuss the difficulty involved in achieving this financing pattern.

Johnson Electronics is considering extending trade credit to some customers previously considered poor risks. Sales would increase by \(150,000 if credit is extended to these new customers. Of the new accounts receivable generated, 5 percent will prove to be uncollectible. Additional collection costs will be 2 percent of sales, and production and selling costs will be 74 percent of sales. The firm is in the 35 percent tax bracket.

Assume that Henderson also needs to increase its level of inventory to support new sales and that inventory turnover is two times.

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