Question

Sherlock Homes, a manufacturer of low cost mobile housing, has $5,000,000 in assets.

  

Temporary current assets	$2,000,000
Permanent current assets	1,550,000
Capital assets	1,450,000
Total assets	$5,000,000

   

Short-term rates are 10 percent. Long-term rates are 15 percent. (Note that long‐term rates imply a return to any equity). Earnings before interest and taxes are $1,060,000. The tax rate is 20 percent.

If long-term financing is perfectly matched (hedged) with long-term asset needs, and the same is true of short-term financing, what will earnings after taxes be?

Answer 1

Long-term Financing = Permanent Current Assets + Capital Assets

= $1,550,000 + $1,450,000 = $3,000,000

Short-term financing = Temporary Current Assets = $2,000,000

Total Interest Expense = Long-term interest expense - Short-term interest expense

= [$3,000,000*15%] + [$2,000,000*10%]

= $450,000 + $200,000 = $650,000

Earnings after taxes = [EBIT - Interest Expense] * [1 - t]

= [$1,060,000 - $650,000] * [1 - 20%]

= $410,000 * 0.80 = $328,000

Earnings after taxes is $328,000

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