14. 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. Short-term financing
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.
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?

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.

a. To determine Lear's earnings after taxes under this financing plan, we need to calculate the interest expense first.

The total fixed assets and half of the permanent current assets will be financed by long-term financing, which costs 10 percent.

The long-term financing amount for fixed assets = $600,000
The long-term financing amount for permanent current assets = ($350,000 / 2) = $175,000

Total long-term financing amount = $600,000 + $175,000 = $775,000

The interest expense from long-term financing = Total long-term financing amount * Interest rate = $775,000 * 10% = $77,500

Earnings before interest and taxes (EBIT) = $200,000

To calculate the earnings after taxes, we need to consider the tax rate, which is 30 percent.

Tax expense = EBIT * Tax rate = $200,000 * 30% = $60,000

Earnings after taxes = EBIT - Interest expense - Tax expense = $200,000 - $77,500 - $60,000 = $62,500

Therefore, Lear's earnings after taxes under this financing plan would be $62,500.

b. In this alternative plan, Lear wishes to finance all fixed assets, permanent current assets, and half of its temporary current assets with long-term financing.

The total temporary current assets amount can be calculated by subtracting the permanent current assets from the total current assets:

Temporary current assets = Total current assets - Permanent current assets = $800,000 - $350,000 = $450,000

Half of the temporary current assets to be financed with long-term financing = $450,000 / 2 = $225,000

Total long-term financing amount = $600,000 (fixed assets) + $350,000 (permanent current assets) + $225,000 (half of temporary current assets) = $1,175,000

The interest expense from long-term financing = Total long-term financing amount * Interest rate = $1,175,000 * 10% = $117,500

Tax expense remains the same at $60,000.

Earnings after taxes = EBIT - Interest expense - Tax expense = $200,000 - $117,500 - $60,000 = $22,500

Therefore, Lear's earnings after taxes under this financing plan would be $22,500.

c. Some of the risks and cost considerations associated with each of these alternative financing strategies include:

- Long-term financing: The cost of long-term financing is generally higher than short-term financing. It may involve higher interest rates and longer repayment periods, leading to higher interest expense and potentially affecting profitability.

- Short-term financing: While short-term financing generally has lower interest rates, it poses the risk of interest rate fluctuations. If interest rates increase, the cost of short-term financing can increase significantly, impacting the company's profitability.

- Mix of long-term and short-term financing: A combination of long-term and short-term financing strategies carries the risk of refinancing or rollover risk. If short-term financing cannot be renewed or refinanced at favorable terms, the company may be forced to secure more expensive financing or face liquidity issues.

- Cost of capital: The choice of financing strategy impacts the cost of capital for the company. Long-term financing usually carries higher interest rates, increasing the cost of capital. It's important to consider the trade-off between the cost of capital and profitability.

- Financial flexibility: Different financing strategies provide varying levels of financial flexibility. Long-term financing can offer stability and predictability in terms of interest expenses but may limit the company's ability to access funds for other needs. Short-term financing can provide more flexibility, but it may require constant monitoring and refinancing.

- Risk management: The choice of financing strategy should align with the company's risk appetite and risk management objectives. Long-term financing may provide stability but can expose the company to interest rate risk. Short-term financing may offer flexibility but carry higher refinancing risks.

Overall, companies need to carefully assess their financial needs, risk profile, cost considerations, and long-term goals when selecting a financing strategy.

a. To determine Lear's earnings after taxes under this financing plan, we first need to calculate the interest expenses for both long-term and short-term financing.

For long-term financing:
Fixed assets = $600,000
Permanent current assets = $350,000

Total assets to be financed = Fixed assets + (0.5 * Permanent current assets) = $600,000 + (0.5 * $350,000) = $775,000

Long-term financing cost = Total assets to be financed * Long-term financing rate = $775,000 * 10% = $77,500

For short-term financing:
Permanent current assets = $350,000

Short-term financing cost = Permanent current assets * Short-term financing rate = $350,000 * 5% = $17,500

Therefore, the total interest expense is $77,500 + $17,500 = $95,000.

Now, we can calculate Lear's earnings after taxes:
Earnings before interest and taxes = $200,000
Interest expense = $95,000
Tax rate = 30%

Earnings after taxes = (Earnings before interest and taxes - Interest expense) * (1 - Tax rate)
Earnings after taxes = ($200,000 - $95,000) * (1 - 0.30) = $105,000 * 0.70 = $73,500

Therefore, Lear's earnings after taxes under this financing plan would be $73,500.

b. To calculate Lear's earnings after taxes under this alternative financing plan, we need to include the temporary current assets.

Temporary current assets = Current assets - Permanent current assets = $800,000 - $350,000 = $450,000

Total assets to be financed = Fixed assets + Permanent current assets + (0.5 * Temporary current assets) = $600,000 + $350,000 + (0.5 * $450,000) = $975,000

Long-term financing cost = Total assets to be financed * Long-term financing rate = $975,000 * 10% = $97,500

Therefore, the total interest expense is $97,500.

Now, we can calculate Lear's earnings after taxes:
Earnings before interest and taxes = $200,000
Interest expense = $97,500
Tax rate = 30%

Earnings after taxes = (Earnings before interest and taxes - Interest expense) * (1 - Tax rate)
Earnings after taxes = ($200,000 - $97,500) * (1 - 0.30) = $102,500 * 0.70 = $71,750

Therefore, Lear's earnings after taxes under this alternative financing plan would be $71,750.

c. Some risks and cost considerations associated with each alternative financing strategy include:

- Long-term financing: The main risk is the higher cost of long-term financing, as it usually has higher interest rates compared to short-term financing. This can lead to higher interest expenses, reducing earnings after taxes. Additionally, long-term financing often involves longer repayment periods, which could lead to higher total interest payments over time.

- Short-term financing: While short-term financing may have lower interest rates, it carries the risk of interest rate fluctuation. If interest rates increase in the future, the cost of short-term financing could rise significantly. Short-term financing also requires more frequent refinancing, which can incur transaction costs.

- Alternative financing plan: By including temporary current assets in the long-term financing strategy, the risk is that these assets may not be fully utilized or may not generate sufficient returns to cover the higher interest expenses. This could result in a lower level of earnings after taxes compared to the first financing plan.

It is important for Lear, Inc. to carefully consider the risks, costs, and potential benefits of each financing strategy before making a decision.