6 Colter Steel has $4, 200, 000 in assets Temporary current assets $1,000,000 Permanent current assets 2.000.000 Fixed assets 1.200.000 Total assets $4,200,000 Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before interest and taxes are $996,000. The tax rate is 40 percent If long-term financing is perfectly matched(synchronized)with long-term asset needs, and the same is true of short-term financing, what will earnings after taxes be? For an example of perfectly matched plans, see Figure 6-5 Solution: Colter steel Long-term financing equals Permanent current assets $2,000,000 Fixed assets 200000 $3,200,000 Short-term financing equals Temporary current assets $l000.000 Long-term interest expense=13%X$3, 200,000 $416000 Short-term interest expense=8%X 1,000,000 80000 Total interest expense $496,000 Earnings before interest and taxes $9960 Interest expense 496.000 Earnings before taxes $500.000 Taxes(40%) 200000 Earnings after taxes $300,000 S-221 CopyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-221 6-8. Colter Steel has $4,200,000 in assets. Temporary current assets................... $1,000,000 Permanent current assets................... 2,000,000 Fixed assets........................................ 1,200,000 Total assets...................................... $4,200,000 Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before interest and taxes are $996,000. The tax rate is 40 percent. If long-term financing is perfectly matched (synchronized) with long-term asset needs, and the same is true of short-term financing, what will earnings after taxes be? For an example of perfectly matched plans, see Figure 6-5. Solution: Colter Steel Long-term financing equals: Permanent current assets $2,000,000 Fixed assets 1,200,000 $3,200,000 Short-term financing equals: Temporary current assets $1,000,000 Long-term interest expense = 13% x $3,200,000 = $ 416,000 Short-term interest expense = 8% x 1,000,000 = 80,000 Total interest expense $ 496,000 Earnings before interest and taxes $ 996,000 Interest expense 496,000 Earnings before taxes $ 500,000 Taxes (40%) 200,000 Earnings after taxes $ 300,000
6-9 In problem 8, assume the term structure of interest rates becomes inverted with short-term rates going to l l percent and long-term rates 4 percentage points lower than short-term rates If all other factors in the problem remain unchanged, what will earnings after Soluti Colter Steel(Continued) Long-term interest expense 7%X$3,200,000=$224,000 Short-term interest expense=11%x 1,000,000 110000 Total interest expense $334.000 Earnings before interest and taxes $996000 Interest exp 334.000 Earnings before taxes $662000 Taxes(40%) 264.800 Earnings after taxes $397,200 Guardian, Inc, is try ing to develop an asset-financing plan. The firm has $400,000 in temporary current assets and $300,000 in permanent current assets. Guard ian 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 b. Given that Guard ian's earnings before interest and taxes are $200,000, calculate earnings after taxes for each of your alternatives c. What would happen if the short- and long-term rates were reversed? CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-222 6-9. In problem 8, assume the term structure of interest rates becomes inverted, with short-term rates going to 11 percent and long-term rates 4 percentage points lower than short-term rates. If all other factors in the problem remain unchanged, what will earnings after taxes be? Solution: Colter Steel (Continued) Long-term interest expense = 7% x $3,200,000 = $224,000 Short-term interest expense = 11% x 1,000,000 = 110,000 Total interest expense $334,000 Earnings before interest and taxes $996,000 Interest expense 334,000 Earnings before taxes $662,000 Taxes (40%) 264,800 Earnings after taxes $397,200 6-10. 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. b. Given that Guardian’s earnings before interest and taxes are $200,000, calculate earnings after taxes for each of your alternatives. c. What would happen if the short- and long-term rates were reversed?