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.
To answer the given questions, let's break down the information step by step:
a. The total assets to be financed with long-term debt (LT Debt) are $775,000. This amount is calculated by adding half of the working capital ($175,000) and the fixed assets ($600,000).
The next step is to calculate the interest expense for long-term debt, which is given as 10% of the total assets financed with LT Debt. So, the interest expense is $775,000 x 0.10 = $77,500.
Now, let's move on to calculating the short-term debt components. $175,000 (half of permanent current) and $450,000 (variable current assets) need to be financed. Since the interest rate for this debt is 5%, we can calculate the interest expense for this debt as follows: ($175,000 + $450,000) x 0.05 = $31,250.
Given the EBIT (Earnings Before Interest and Taxes) of $200,000, we can calculate the Earnings Before Taxes (EBT) by subtracting the total interest expenses ($77,500 + $31,250) from the EBIT. So, EBT = $200,000 - $77,500 - $31,250 = $108,750.
Applying the tax rate of 30% to the EBT, we can calculate the taxes as follows: $108,750 x 0.30 = $32,625.
Finally, subtracting the taxes from the EBT, we can calculate the net income: $108,750 - $32,625 = $76,125.
b. Similarly, let's calculate the interest expense for the long-term debt and short-term debt components.
The total assets to be financed with LT Debt are $1,175,000 (calculated by adding half of the variable current assets, $225,000, half of permanent current, $350,000, and the fixed assets, $600,000).
The interest expense for the long-term debt is $1,175,000 x 0.10 = $117,500.
The interest expense for the short-term debt ($225,000 + $350,000) at a rate of 5% is ($575,000 x 0.05) = $28,750.
Using the given EBIT of $200,000 and subtracting the interest expenses, we get the Earnings Before Taxes (EBT): $200,000 - $117,500 - $11,250 = $71,250.
Applying the tax rate of 30% to the EBT, the taxes can be calculated as follows: $71,250 x 0.30 = $21,375.
Finally, subtracting the taxes from the EBT, we can calculate the net income: $71,250 - $21,375 = $49,875.
c. The main principle to consider here is the matching principle, which suggests that long-term needs should be financed with long-term liabilities. The cost of long-term debt, i.e., the interest rate of 10%, may be higher compared to the 5% interest rate for short-term debt. However, using long-term debt provides a stable source of funding.
On the other hand, short-term debt only lasts for a maximum period of one year and then needs to be renewed. This can pose challenges, especially when it comes to procuring short-term loans when they are needed.
It is essential to match the financing of fixed assets and permanent current assets (working capital) with long-term debt. However, financing too much of current assets with LT-debt can be expensive and negatively impact the company's bottom line, as shown in the examples above.