Question

Bobo’s Jojoba Products Ltd. has $600,000 in current assets of
which $200,000 are

considered to be permanent current assets. They also have
$1,000,000 in capital

assets. Their tax rate is 40%. They want to finance all of their
capital assets and

one-half of their permanent current assets with long-term financing
at 12%. The

balance would be financed with short term financing at 10%.

They could reduce their interest expense by using more short-term
financing.

Give two reasons why they might not want to do this.

Answer #1

Reason 1

High proportion of debt in capital structure would result in high risk and hence equity holder will demand higher returns. Which will result in higher WACC hence it is not good for company to raise debt beyond it's optimal capital structure though the cost of debt looks cheaper compared to cost of equity.

Reason 2

If company is not confident about the future earnings that means the future earnings are volatile, it is not advisable to have higher debts as debt service payments are fixed and company have to pay it no matter company earns profit or not. Hence in company which has volatile future earnings debt would add more burden in situations where company profit shrinks.

Lear Inc. has $890,000 in current assets, $395,000 of which are
considered permanent current assets. In addition, the firm has
$690,000 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. The balance will be financed with short-term
financing, which currently costs 4 percent. Lear’s earnings before
interest and taxes are $290,000. Determine Lear’s earnings after
taxes under this financing plan. The tax rate...

Lear Inc. has $900,000 in current assets, $400,000 of which are
considered permanent current assets. In addition, the firm has
$700,000 invested in fixed assets.
a. Lear wishes to finance all fixed assets and
half of its permanent current assets with long-term financing
costing 8 percent. The balance will be financed with short-term
financing, which currently costs 5 percent. Lear’s earnings before
interest and taxes are $300,000. Determine Lear’s earnings after
taxes under this financing plan. The tax rate...

Lear Inc. has $1,020,000 in current assets, $460,000 of which
are considered permanent current assets. In addition, the firm has
$820,000 invested in fixed assets.
a. Lear wishes to finance all fixed assets and
half of its permanent current assets with long-term financing
costing 8 percent. The balance will be financed with short-term
financing, which currently costs 5 percent. Lear’s earnings before
interest and taxes are $420,000. Determine Lear’s earnings after
taxes under this financing plan. The tax rate...

Lear, Inc. has $1,600,000 in current assets, $670,000 of which
are considered permanent current assets. In addition, the firm has
$920,000 invested in capital assets.
a. Lear wishes to finance all capital 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 $520,000. Determine
Lear’s earnings after taxes under this financing plan. The tax rate
is 30 percent.
Earnings after
taxes ...

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...

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...

Date Wireless has the following
assets:
Current assets :
Temporary
$1,150,000
Permanent
1,300,000
Capital
assets
7,750,000
Total assets
$10,200,000
Its operating profit (EBIT) is expected to be $2.5 million. Its
tax rate is 30 percent. Shares are valued $20. Capital structure is
either short-term financing at 5 percent or equity. There is no
long-term debt. (Round the final answers to 2 decimal
places.)
a.
Calculate expected earnings per
share (EPS) if the firm is perfectly hedged.
...

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,...

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...

Market Value Capital Structure
Suppose the Schoof Company has this book value balance
sheet:
Current assets
$30,000,000
Current liabilities
$10,000,000
Fixed assets
50,000,000
Long-term debt
30,000,000
Common stock
(1 million shares)
1,000,000
Retained earnings
39,000,000
Total assets
$80,000,000
Total claims
$80,000,000
The current liabilities consist entirely of notes payable to
banks, and the interest rate on this debt is 11%, the same as the
rate on new bank loans. These bank loans are not used for seasonal
financing but instead...

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