Problem
Collins Systems Inc. is trying to develop an asset-financing plan. The firm has $300,000 in temporary current assets and $200,000 in permanent current assets. Collins also has $400,000 in capital assets. Assume a tax rate of 40 percent.
Construct two alternative financing plans for Collins. One of the plans should be conservative, with 80 percent of assets financed by long-term sources, and the other should be aggressive, with only 30 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.
Given that Collins's earnings before interest and taxes are $180,000, calculate earnings after taxes for each of your alternatives.
What would happen if the short- and long-term rates were reversed?