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.
Please help me get started solving this
To solve this problem, we need to calculate the earnings after taxes for Lear, Inc. using two different financing plans. Let's break down the problem into two parts:
Part a: Financing half of permanent current assets and all fixed assets with long-term financing
1. Find the amount of permanent current assets financed with long-term financing:
Permanent current assets financed = 0.5 * $350,000 = $175,000
2. Calculate the interest expense on long-term financing:
Interest expense = Permanent current assets financed * Long-term financing rate = $175,000 * 10% = $17,500
3. Calculate the interest expense on short-term financing:
Short-term financing rate = 5%
Short-term financing expense = (Current assets - Permanent current assets) * Short-term financing rate
= ($800,000 - $350,000) * 5%
= $450,000 * 5%
= $22,500
4. Calculate earnings before taxes:
Earnings before taxes = Earnings before interest and taxes - Interest expense
= $200,000 - ($17,500 + $22,500)
= $160,000
5. Calculate earnings after taxes:
Tax rate = 30%
Earnings after taxes = Earnings before taxes * (1 - Tax rate)
= $160,000 * (1 - 0.30)
= $160,000 * 0.70
= $112,000
Part b: Financing half of temporary current assets, all permanent current assets, and all fixed assets with long-term financing
(Note: Temporary current assets are the difference between current assets and permanent current assets)
1. Find the amount of temporary current assets financed with long-term financing:
Temporary current assets = Current assets - Permanent current assets
= $800,000 - $350,000
= $450,000
Temporary current assets financed = 0.5 * $450,000 = $225,000
2. Calculate the interest expense on long-term financing (including temporary current assets):
Interest expense = (Permanent current assets + Temporary current assets financed) * Long-term financing rate
= ($350,000 + $225,000) * 10%
= $575,000 * 10%
= $57,500
3. Calculate the interest expense on short-term financing (temporary current assets):
Short-term financing expense = Temporary current assets financed * Short-term financing rate
= $225,000 * 5%
= $11,250
4. Calculate earnings before taxes:
Earnings before taxes = Earnings before interest and taxes - Interest expense
= $200,000 - ($57,500 + $11,250)
= $131,250
5. Calculate earnings after taxes:
Earnings after taxes = Earnings before taxes * (1 - Tax rate)
= $131,250 * (1 - 0.30)
= $131,250 * 0.70
= $91,875
Therefore, the earnings after taxes for Lear, Inc. under part a financing plan is $112,000, and under part b financing plan is $91,875.