Question

Sherlock Homes, a manufacturer of low cost mobile housing, has $4,950,000 in assets.

  

Temporary current assets	$1,900,000
Permanent current assets	1,545,000
Capital assets	1,505,000
Total assets	$4,950,000

   

Short-term rates are 9 percent. Long-term rates are 14 percent. (Note that long‐term rates imply a return to any equity). Earnings before interest and taxes are $1,050,000. The tax rate is 40 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? For an example of perfectly hedged plans, see Figure 6-8.

Earnings after taxes            $   

Answer 1

Computation of Earnings After Taxes :
Sherlock Homes
Particulars	Amount
Long Term Financing equals :
Permanent Current assets	$1,545,000
Capital assets	$1,505,000
Total	$3,050,000
Short Term Financing equals:
Temporary Current assets	$1,900,000
Total	$1,900,000
Long term Interest expense (Note 1)	$427,000
Short term Interest expense (Note 2)	$171,000
Total interest expenses	$598,000
Earnings before Interest and Taxes	$1,050,000
Less: Interest expense	$598,000
Earnings before Taxes	$452,000
Less : Taxes ( Earnings before Taxes × 40% Tax rate) ($452,000× 40%)	$180,800
Earnings After Taxes	$271,200

Notes:

1. Long term Interest expense = Total long term financing equals × long term rates

= $3,050,000 × 14%

=$ 427,000

2. Short term interInt expense = Total short term financing equals × short term rates

= $1,900,000 × 9%

=$171,000