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.
Could you please walk me through on how to get started.
First compute the interest paid annually. In (a), it is 10% of $600,000 plus 5% of $175,000. Subtract that from the 200,000 before T&I, and then take 30% off of that for taxes.
Do (b) similarly. The interest paid will be different.
To solve this problem, we need to calculate the interest expense for both scenarios, deduct the interest expense from earnings before interest and taxes (EBIT), and then calculate the earnings after taxes. Let's break it down step by step:
a. In this scenario, half of the permanent current assets will be financed with long-term financing, while the remaining half and the fixed assets will be financed with short-term financing. The interest rate for long-term financing is 10%, and the interest rate for short-term financing is 5%.
Step 1: Calculate the interest expense for long-term financing on fixed assets and half of the permanent current assets.
Interest expense = (Fixed assets + (Permanent current assets / 2)) * Long-term interest rate
Interest expense = ($600,000 + ($350,000 / 2)) * 0.10
Step 2: Calculate the interest expense for short-term financing on the remaining half of the permanent current assets.
Interest expense = (Permanent current assets / 2) * Short-term interest rate
Interest expense = ($350,000 / 2) * 0.05
Step 3: Calculate the total interest expense by summing the interest expense from step 1 and step 2.
Step 4: Calculate earnings before taxes (EBT) by deducting the total interest expense from EBIT.
EBT = EBIT - Total interest expense
Step 5: Calculate earnings after taxes (EAT) by deducting the tax amount from EBT.
EAT = EBT * (1 - Tax rate)
b. In this scenario, all fixed assets, permanent current assets, and half of the temporary current assets will be financed with long-term financing. The remaining half of the temporary current assets will be financed with short-term financing. The interest rates remain the same as in part a.
Step 1: Calculate the interest expense for long-term financing on fixed assets, permanent current assets, and half of the temporary current assets.
Interest expense = (Fixed assets + Permanent current assets + (Temporary current assets / 2)) * Long-term interest rate
Interest expense = ($600,000 + $350,000 + ($800,000 / 2)) * 0.10
Step 2: Calculate the interest expense for short-term financing on the remaining half of the temporary current assets.
Interest expense = (Temporary current assets / 2) * Short-term interest rate
Interest expense = ($800,000 / 2) * 0.05
Step 3: Calculate the total interest expense by summing the interest expense from step 1 and step 2.
Step 4: Calculate EBT by deducting the total interest expense from EBIT.
EBT = EBIT - Total interest expense
Step 5: Calculate EAT by deducting the tax amount from EBT.
EAT = EBT * (1 - Tax rate)
By following these steps and plugging in the given values, you can find the respective earnings after taxes for both scenarios.