6-8. Solution:
Biochemical Corp.
Cost of Three-Year Fixed Cost Financing
9. Short-term versus longer-term borrowing (LO3) Sauer Food Company has decided to
buy a new computer system with an expected life of three years. The cost is $150,000. The
company can borrow $150,000 for three years at 10 percent annual interest or for one year
at 8 percent annual interest.
How much would Sauer Food Company save in interest over the three-year life of the
computer system if the one-year loan is utilized and the loan is rolled over (reborrowed)
each year at the same 8 percent rate? Compare this to the 10 percent three-year loan. What
if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3?
What would be the total interest cost compared to the 10 percent, three-year loan?
6-9. Solution:
Sauer Food Company
If Rates Are Constant
$150,000 borrowed × 8% per annum × 3 years =
10. Optimal policy mix (LO5) Assume that Hogan Surgical Instruments Co. has $2,500,000 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 $2,500,000 will be 10 percent, and with a
long-term financing plan, the financing costs on the $2,500,000 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 $2,500,000 × 18% = $450,000
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 $840,000 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 $840,000 will be 9 percent, and with a long-term
financing plan, the financing costs on the $840,000 will be 11 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. 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
6-11. (Continued)
c. Moderate approach
Low liquidity $840,000 × 15% = $126,000
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:
Permanent current assets $2,000,000
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
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)
Long-term interest expense = 6% × $3,200,000 = $192,000
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.
a. Temporary current assets $ 400,000
Permanent current assets 300,000
6-14. (Continued)
b. Conservative Aggressive
EBIT $200,000 $200,000
– Int 165,000 153,750
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
$840,000 – $370,000 = $470,000
