Question

Guardian Inc us trying to develop an asset-financing plan. The firm has $400,000 tenporary current assets and 300,000 in permanent current assets. Guardian also has $500,000 in fixed assets. Assume a tax rate od 40 percent.

a. Constrct 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 financed bt lond-term sources. The current interest rate is 15 percent on long-term funds and 10 percent on short- term financing.

b. Given the Guardian's earnings before interest interest and taxes are $200,000, calcute earnings after taxes fir each of your alternatives.

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

Answer 1

Temporary current assets	4,00,000
Permanent current assets	3,00,000
Total current assets	7,00,000
Fixed assets	5,00,000
Total assets	12,00,000
Option 1	Amount	interest cost
75% long term sources @15%	9,00,000	1,35,000
25% short term sources @10%	3,00,000	30,000
Total	12,00,000	1,65,000
EBIT	2,00,000
Less : Total interest	1,65,000
Income before taxes	35,000
Less : Taxes @40%	14,000
Net Income	21,000
Option 2	Amount	interest cost
56.25% long term sources @15%	6,75,000	1,01,250
43.75% short term sources @10%	5,25,000	52,500
Total	12,00,000	1,53,750
EBIT	2,00,000
Less : Total interest	1,53,750
Income before taxes	46,250
Less : Taxes @40%	18,500
Net Income	27,750
C. when capital structure reversed
Option 1	Amount	interest cost
25% long term sources @15%	3,00,000	45,000
75% short term sources @10%	9,00,000	90,000
Total	12,00,000	1,35,000
EBIT	2,00,000
Less : Total interest	1,35,000
Income before taxes	65,000
Less : Taxes @40%	26,000
Net Income	39,000
Option 2	Amount	interest cost
43.75% long term sources @15%	5,25,000	78,750
56.25% short term sources @10%	6,75,000	67,500
Total	12,00,000	1,46,250
EBIT	2,00,000
Less : Total interest	1,46,250
Income before taxes	53,750
Less : Taxes @40%	21,500
Net Income	32,250