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Chapter 06: Working Capital and the Financing Decision
6-11
b. If Short-term Rates Change
1st year $200,000 × .10 = $20,000
2nd year $200,000 × .15 = $30,000
10. Optimal policy mix (LO5) Assume that Hogan Surgical Instruments Co. has $2,000,000
in assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 18
percent, but with a high liquidity plan, the return will be 14 percent. If the firm goes with a
short-term financing plan, the financing costs on the $2,000,000 will be 10 percent, and
with a long-term financing plan, the financing costs on the $2,000,000 will be 12 percent.
(Review Table 6-11 for parts a, b, and c of this problem.)
a. Compute the anticipated return after financing costs with the most aggressive asset-
financing mix.
b. Compute the anticipated return after financing costs with the most conservative asset-
financing mix.
c. Compute the anticipated return after financing costs with the two moderate approaches
to the asset-financing mix.
d. Would you necessarily accept the plan with the highest return after financing costs?
Briefly explain.
6-10. Solution:
Hogan Surgical Instruments Company
a. Most aggressive
Low liquidity $2,000,000 × 18% = $360,000
Chapter 06: Working Capital and the Financing Decision
6-12
b. Most conservative
High liquidity $2,000,000 × 14% = $280,000
c. Moderate approach
Low liquidity $2,000,000 × 18% = $360,000
OR
High liquidity $2,000,000 × 14% = $280,000
6-10. (Continued)
d. You may not necessarily select the plan with the highest
11. Optimal policy mix (LO5) Assume that Atlas Sporting Goods, Inc., has $800,000 in
assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 15 percent,
but with a high-liquidity plan the return will be 12 percent. If the firm goes with a short-
term financing plan, the financing costs on the $800,000 will be 8 percent, and with a long-
term financing plan, the financing costs on the $800,000 will be 10 percent. (Review
Table 6-11 for parts a, b, and c of this problem.)
a. Compute the anticipated return after financing costs with the most aggressive asset-
financing mix.
b. Compute the anticipated return after financing costs with the most conservative asset-
financing mix.
c. Compute the anticipated return after financing costs with the two moderate approaches
to the asset-financing mix.
Chapter 06: Working Capital and the Financing Decision
6-13
d. If the firm used the most aggressive asset-financing mix described in part a and had the
anticipated return you computed for part a, what would earnings per share be if the tax
rate on the anticipated return was 30 percent and there were 20,000 shares outstanding?
e. Now assume the most conservative asset-financing mix described in part b will be
utilized. The tax rate will be 30 percent. Also assume there will only be 5,000 shares
outstanding. What will earnings per share be? Would it be higher or lower than the
earnings per share computed for the most aggressive plan computed in part d?
6-11. Solution:
Atlas Sporting Goods, Inc.
a. Most aggressive
Low liquidity $800,000 × 15% = $120,000
b. Most conservative
High liquidity $800,000 × 12% = $ 96,000
6-11. (Continued)
c. Moderate approach
Low liquidity $800,000 × 15% = $120,000
OR
High liquidity $800,000 × 12% = $ 96,000
Chapter 06: Working Capital and the Financing Decision
6-14
d. Anticipated return $ 56,000
– taxes (30%) 16,800
Earnings after taxes 39,200
12. Matching asset mix and financing plans (LO3) Winfrey Diet Food Corp. has $4,500,000
in assets.
Temporary current assets ........................ $1,000,000
Permanent current assets ......................... 1,500,000
Fixed assets ............................................ 2,000,000
Total assets ....................................... $4,500,000
Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before interest and
taxes are $960,000. 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 on page 168.
6-12. Solution:
Chapter 06: Working Capital and the Financing Decision
6-15
Winfrey Diet Food Corporation
Long-term financing equals:
Permanent current assets $1,500,000
Fixed assets 2,000,000
$3,500,000
Short-term financing equals:
Temporary current assets $1,000,000
13. Impact of term structure of interest rates on financing plans (LO4) In Problem 12,
assume the term structure of interest rates becomes inverted, with short-term rates going to
12 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?
6-13. Solution:
Chapter 06: Working Capital and the Financing Decision
6-16
Winfrey Diet Food Corporation (Continued)
Long-term interest expense = 8% × $3,500,000 = $280,000
Short-term interest expense = 12% × 1,000,000 = 120,000
Total interest expense $400,000
14. Conservative versus aggressive financing (LO5) Collins Systems, Inc., is trying to
develop an asset-financing plan. The firm has $300,000 in temporary current assets and
$200,000 in permanent current assets. Collins also has $400,000 in fixed assets.
a. Construct two alternative financing plans for the firm. One of the plans should be
conservative, with 80 percent of assets financed by long-term sources and the rest
financed by short-term sources. The other plan should be aggressive, with only 30
percent of assets financed by long-term sources and the remaining assets financed by
short-term sources. The current interest rate is 15 percent on long-term funds and 10
percent on short-term financing. Compute the annual interest payments under each
plan.
b. Given that Collins’s earnings before interest and taxes are $180,000, calculate earnings
after taxes for each of your alternatives. Assume a tax rate of 40 percent.
6-14. Solution:
Collins System Inc.
a. Temporary current assets $300,000
Permanent current assets 200,000
Fixed assets 400,000
Total assets $900,000
Conservative
% of Interest Interest
Amount Total Rate Expense
Chapter 06: Working Capital and the Financing Decision
6-17
Aggressive
% of Interest Interest
Amount Total Rate Expense
6-14. (Continued)
b. Conservative Aggressive
EBIT $180,000 $180,000
–Int 126,000 103,500
15. Alternative financing plans (LO5) Lear, Inc., has $800,000 in current assets, $350,000 of
which are considered permanent current assets. In addition, the firm has $600,000 invested
in fixed assets.
a. Lear wishes to finance all fixed assets and half of its permanent current assets with
long-term financing costing 10 percent. The balance will be financed with short-term
financing, which currently costs 5 percent. Lear’s earnings before interest and taxes are
$200,000. 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 $200,000. 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?
Chapter 06: Working Capital and the Financing Decision
6-18
6-15. Solution:
Lear, Inc.
a.
Current assets – permanent current assets = temporary current assets
$800,000 – $350,000 = $450,000
Long-term interest expense = 10% [$600,000 + ½ ($350,000)]
= 10% ($775,000)
= $77,500
Earnings before interest and taxes $200,000
Interest expense 108,750
6-15. (Continued)
b. Alternative financing plan
Long-term interest expense = 10% [$600,000 + $350,000
Chapter 06: Working Capital and the Financing Decision
6-19
= $11,250
c. The alternative financing plan which calls for more financing
by high-cost debt is more expensive and reduces aftertax
income by $14,000. However, we must not automatically
reject this plan because of its higher cost since it has less risk.
16. Expectations hypothesis and interest rates (LO4) Using the expectations hypothesis
theory for the term structure of interest rates, determine the expected return for securities
with maturities of two, three, and four years based on the following data. Do an analysis
similar to that in the right-hand portion of Table 6-6.
1-year T-bill at beginning of year 1……. 5%
1-year T-bill at beginning of year 2……. 6%
1-year T-bill at beginning of year 3……. 8%
1-year T-bill at beginning of year 4…… 10%
6-16. Solution:
Chapter 06: Working Capital and the Financing Decision
6-20
17. Expectations hypothesis and interest rates (LO4) Using the expectations hypothesis
theory for the term structure of interest rates, determine the expected return for securities
with maturities of two, three, and four years based on the following data. Do an analysis
similar to that in the right-hand portion of Table 6-6.
1-year T-bill at beginning of year 1…… 3%
1-year T-bill at beginning of year 2…… 6%
1-year T-bill at beginning of year 3…… 5%
1-year T-bill at beginning of year 4…… 8%
6-17. Solution:
18. Interest costs under alternative plans (LO3) Carmen’s Beauty Salon has estimated
monthly financing requirements for the next six months as follows:
January ................ $8,000 April................. $8,000
February............... 2,000 May .................. 9,000
March .................. 3,000 June .................. 4,000
Short-term financing will be utilized for the next six months. Projected annual interest
rates are:
January ................ 8.0% April................. 15.0%
February............... 9.0% May .................. 12.0%
March .................. 12.0% June .................. 12.0%
a. Compute total dollar interest payments for the six months. To convert an annual rate
to a monthly rate, divide by 12. Then multiply this value times the monthly balance. To
get your answer sum up the monthly interest payments.
