ALTERNATIVE FINANCING PLANS

Current assets – permanent current assets = temporary current assets

$800,000 – $350,000 = $450,000

Short-term interest expense = 5% [$450,000 + ½ ($350,000)] = 5% ($625,000) = $31,250

Long-term interest expense = 10% [$600,000 + ½ ($350,000)] = 10% ($775,000) = $77,500 expense =

10% [$600,000 + ½ ($350,000)] = 10% ($775,000)

Total interest expense = $31,250 + $77,500 = $108,750

Earnings before interest and taxes $200,000

Interest expense 108,750

Earnings before taxes $ 91,250

Taxes (30%) 27,375

Earnings after taxes $ 63,875

Alternative financing plan

Short-term interest expense = 5% [½ ($450,000)] = 5% (225,000) = $11,250

Long-term interest expense = 10% [$600,000 + $350,000+ ½ ($450,000)]

= 10% ($1,175,000) = $117,500

Total interest expense = $11,250 + $117,500 = $128,750

Earnings before interest and taxes $200,000

Interest 128,750

Earnings before taxes $ 71,250

Taxes (30%) 21,375

Earnings after taxes $ 49,875

In the first plan, the company is financing long term assets with short term liabilities, which is not a sound

source of financing. Short term financing is only taken for a period of 1 year or less, after that it must be

renewed. One issue that can be faced is difficulty renewing the short-term loans when they become due.

Another risk that should be considered is that the short term rates can increase in the future, which would

cause an increase in the interest expense. Since the short term rates are currently lower, funding through

short term borrowing would appear to be the better deal for the company, short term borrowing for

funding long term assets is not advisable. The increased financing by high-cost debt is more expensive

and reduces the after tax income by $14,000.

In the second plan, the company is financing a large part of its short term assets from long term liabilities

which will cause them to pay excess interest. The company should also take into consideration that when

the need to finance short term is over, it would still be paying interest for that portion of financing which

is no longer required. The ideal way of financing assets is: long-term assets should to be financed with

long term liabilities and capital. Short term assets should be financed with short term liabilities and

capital.