6 Chapter Problems
6-A. Gary's Pipe and Steel company expects sales next year to be $800,000 if the economy is strong, $500,000 if the economy is steady, and $350,000 if the economy is weak. Gary believes there is a 20 percent probability the economy will be strong, a 50 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected level of sales for next year?
6-A. Solution: Gary's Pipe and Steel Company State of Econom y Strong Steady Weak Expected Outcome $160,000 250,000 105,000 $515,000
Sales $800,000 500,000 350,000
Probability .20 .50 .30
Expected level of sales =
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6-B. Tobin Supplies Company expects sales next year to be $500,000. Inventory and accounts receivable will increase $90,000 to accommodate this sales level. The company has a steady profit margin of 12 percent with a 40 percent dividend payout. How much external financing will Tobin Supplies Company have to seek? Assume there is no increase in liabilities other than that which will occur with the external financing.
6-B. Solution: Tobin Supplies Company $500,000 .12 60,000 24,000 $ 36,000 $ 90,000 36,000 $ 54,000 Sales Profit margin Net income Dividends (40%) Increase in retained earnings Increase in assets Increase in retained earnings External funds needed
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6-C. Sauer Food Company has decided to buy a new computer system with an expected life of three years. The cost is $150,000. The company can borrow $150,000 for three years at 10 percent annual interest or for one year at 8 percent annual interest. How much would Sauer Food Company save in interest over the three-year life of the computer system if the one-year loan is utilized and the loan is rolled over (reborrowed) each year at the same 8 percent rate? Compare this to the 10 percent three-year loan. What if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3? What would be the total interest cost compared to the 10 percent, three-year loan?
6-C. Solution: Sauer Food Company If Rates Are Constant $150,000 borrowed 8% per annum 3 years = $36,000 interest cost $150,000 borrowed 10% per annum 3 years = $45,000 interest cost $45,000 $36,000 = $9,000 interest savings borrowing short-term If Short-term Rates Change 1st year 2nd year 3rd year $150,000 .08 = $12,000 $150,000 .13 = $19,500 $15,000 .18 = $27,000 Total = $58,500 $58,500 $45,000 = $13,500 extra interest costs borrowing short-term.
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6-D. Colter Steel has $4,200,000 in assets. Temporary current assets......................... Permanent current assets.......................... Fixed assets.............................................. Total assets......................................... $1,000,000 2,000,000 1,200,000 $4,200,000
Short-term are rates 8 percent. Long-term rates are 13 percent. Earnings before interest and taxes are $996,000. The tax rate is 40 percent. If long-term financing is perfectly matched (synchronized) with long-term asset needs, and the same is true of short-term financing, what will earnings after taxes be? For a graphical example of perfectly matched plans, see Figure 6-5.
6-D. Solution: Colter Steel Long-term financing equals: Permanent current assets Fixed assets Short-term financing equals: Temporary current assets Long-term interest expense = 13% $3,200,000 = Short-term interest expense = 8% 1,000,000 = Total interest expense Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes $1,000,000 $ 416,000 80,000 $ 496,000 $ 996,000 496,000 $ 500,000 200,000 $ 300,000 $2,000,000 1,200,000 $3,200,000
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6-E. Guardian, Inc., is trying to develop an asset-financing plan. The firm has $400,000 in temporary current assets and $300,000 in permanent current assets. Guardian also has $500,000 in fixed assets. Assume a tax rate of 40 percent. a. Construct two alternative financing plans for Guardian. One of the plans should be conservative, with 75 percent of assets financed by long-term sources, and the other should be aggressive, with only 56.25 percent of assets financed by long-term sources. The current interest rate is 15 percent on long-term funds and 10 percent on short-term financing. b. Given that Guardian's earnings before interest and taxes are $200,000, calculate earnings after taxes for each of your alternatives. c. What would happen if the short-and long-term rates were reversed?
6-E. Solution: Guardian, Inc. a. Temporary current assets Permanent current assets Fixed assets Total assets Conservative % of Interest Interest Amount Total Rate Expense $1,200,000 .75 = $900,000 .15 = $135,000 Long-term $1,200,000 .25 = $300,000 .10 = 30,000 Short-term Total interest charge $165,000 Aggressive $1,200,000 .5625 = $675,000 .15 = $1,200,000 .4375 = $525,000 .10 = Total interest charge $101,250 Long-term 52,500 Short-term $153,750 $ 400,000 300,000 500,000 $1,200,000
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6-E. (Continued) b. EBIT Int EBT Tax 40% EAT c. Reversed: Conservative $1,200,000 .75 = $900,000 .10 = $ 90,000 Long-term $1,200,000 .25 = $300,000 .15 = 45,000 Short-term Total interest charge $135,000 Aggressive $1,200,000 .5625 = $675,000 .10 =$67,500 Long-term $1,200,000 .4375 = $525,000 .15 = 78,750 Short-term Total interest charge $146,250 Reversed EBIT Int EBT Tax 40% EAT Conservative $200,000 135,000 65,000 26,000 $ 39,000 Aggressive $200,000 146,250 53,750 21,500 $ 32,250 Conservative $200,000 165,000 35,000 14,000 $ 21,000 Aggressive $200,000 153,750 46,250 18,500 $ 27,750
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