6-11. Solution:
Atlas Sporting Goods Inc.
a. Most aggressive
6-11. (Continued)
c. Moderate approach
OR
It is higher ($1.18 vs. $1.76)
12. Matching asset mix and financing plans (LO3) 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 a
graphical example of perfectly matched plans, see Figure 6-5.
6-12. Solution:
Colter Steel
Long-term financing equals:
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
11 percent and long-term rates 5 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:
Colter Steel (Continued)
14. Conservative versus aggressive financing (LO5) 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?
6-14. Solution:
Guardian Inc.
Conservative
% of Interest Interest
Amount Total Rate Expense
Aggressive
6-14. (Continued)
b. Conservative Aggressive
c. Reversed:
Conservative
Aggressive
Reversed Conservative Aggressive
15. Alternative financing plans (LO5) 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?
6-15. Solution:
Lear Inc.
a.
Current assets – Permanent current assets = Temporary current
assets
Earnings before interest and taxes $240,000
6-15. (Continued)
b. Alternative financing plan
Long-term interest expense = 8% [$640,000 + $370,000
Short-term interest expense = 7% [½($470,000)]
Earnings before interest and taxes $240,000
c. The alternative financing plan, which calls for more
financing by high-cost debt, is more expensive and reduces
aftertax income by $2,940. However, we must not
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 Table 6-6.
1-year T-bill at beginning of year 1 6%
1-year T-bill at beginning of year 2 7%
1-year T-bill at beginning of year 3 9%
1-year T-bill at beginning of year 4 11%
6-16. Solution:
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…… 5%
1-year T-bill at beginning of year 2…… 8%
1-year T-bill at beginning of year 3…… 7%
1-year T-bill at beginning of year 4…… 10%
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…………….. $8,500 April……………… $8,500
February…………… 2,500 May………………. 9,500
March………………. 3,500 June………………. 4,500
Short-term financing will be utilized for the next six months. Projected annual interest
rates:
January…………….. 9.0% April……………… 16.0%
February…………… 10.0% May………………. 12.0%
March………………. 13.0% 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, add up the monthly interest payments.
b. If long-term financing at 12 percent had been utilized throughout the six months, would
the total-dollar interest payments be larger or smaller? Compute the interest owed over
the six months and compare your answer to that in part a.
6-18. Solution:
Carmen’s Beauty Salon
a. Short-term financing
Month Rate
On Monthly
Basis Amount
Actual
Interest
January 9% 0.75% $8,500 $ 63.75
6-18. (Continued)
b. Long-term financing
Month Rate
On Monthly
Basis Amount
Actual
Interest
January 12% 1% $8,500 $ 85.00
February 12% 1% $2,500 $ 25.00
Total dollar interest payments would be larger under the
short-term financing plan as described in part b.
19. Break-even point in interest rates (LO3) In Problem 18, what long-term interest rate
would represent a break-even point between using short-term financing as described in part
a and long-term financing? (Hint: Divide the interest payments in 18a by the amount of
total funds provided for the six months and multiply by 12.)
6-19. Solution:
Carmen’s Beauty Salon (Continued)
Divide the total interest payments in part (a) of $375.35 by the
total amount of funds extended $37,000 ($8,500 + 2,500 + 3,500
+ 8,500 + 9,500 + 4,500) and multiply by 12.
Interest $375.35 1.014% Monthly rate
Principal $37,000
= =
20. Cash receipts schedule (LO1) Eastern Auto Parts Inc. has 15 percent of its sales paid for
in cash and 85 percent on credit. All credit accounts are collected in the following month.
Assume the following sales:
January $65,000
February 55,000
March 100,000
April 45,000
Sales in December of the prior year were $75,000.
Prepare a cash receipts schedule for January through April.
6-20. Solution:
Eastern Auto Parts
Jan Feb Mar Apr
Sales $65,000 $55,000 $100,000 $45,000
21. Level production and related financing effects (LO3) Bombs Away Video Games
Corporation has forecasted the following monthly sales:
January………….. $100,000 July………….. $ 45,000
February………… 93,000 August……… 45,000
March……………. 25,000 September.. . 55,000
April……………… 25,000 October…….. 85,000
May………………. 20,000 November…. 105,000
June………………. 35,000 December…. 123,000
Total annual sales = $756,000
Bombs Away Video Games sells the popular Strafe and Capture video game. It sells for
$5 per unit and costs $2 per unit to produce. A level production policy is followed. Each
month’s production is equal to annual sales (in units) divided by 12.
Of each month’s sales, 30 percent are for cash and 70 percent are on account. All
accounts receivable are collected in the month after the sale is made.
a. Construct a monthly production and inventory schedule in units. Beginning inventory
in January is 25,000 units. (Note: To do part a, you should work in terms of units of
production and units of sales.)
b. Prepare a monthly schedule of cash receipts. Sales in the December before the planning
year are $100,000. Work part b using dollars.
c. Determine a cash payments schedule for January through December. The production
costs of $2 per unit are paid for in the month in which they occur. Other cash payments,
besides those for production costs, are $45,000 per month.
d. Prepare a monthly cash budget for January through December using the cash receipts
schedule from part b and the cash payments schedule from part c. The beginning cash
balance is $5,000, which is also the minimum desired.