Homework Help Forum: Finance

Posted by oreo on Sunday, October 25, 2009 at 1:52pm.

a. 175,000(half of working capital)+600,000(fixed assets)=775,000 in assets to be financed with LT Debt (10% interest rate) The other $175,000(half of permanent current) will be financed at 5% as well as the 450,000 in variable current assets. ($625,000x.05) The company has no equity! (It's an American bank) EBIT: 200,000 LT Expense: 77500 ST Expense: 31250 EBT: 108750 Taxes (30%): 32625 Net Income: 76125 b. 225,000(half of variable current assets)+350,000(permanent current)+600,000(all fixed)=1175000 borrowed at 10% EBIT: 200,000 LT Expense: 117500 ST Expense: 11250 EBT: 71250 Tax@30%: 21375 Net Income: 49875 c. The main part to these questions is the idea of the matching principle, that is, long-term needs ought to be financed with long term liabilities. The cost of long-term debt is greater, in this case 10% versus 5%, but provides for a stable funding source. Short term debt only has a period of 1 year at its max, and then it must be renewed. One problem that can be faced is difficulty in procuring short-term loans when they are needed. Fixed assets and current assets that are considered to be permanent (known as working capital) need to be financed with LT-debt. On the other hand, financing too much of current assets with LT-debt is expensive and obviously (in the examples above) affects your bottom line.

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