Working Capital Problem 14 Guardian Inc. Is Trying To Develo

Working Capitalproblem 14 Guardian Inc Is Trying To Develop An Asset

Guardian Inc is trying to develop an asset financing plan. The firm has $400,000 in temporary current assets and $300,000 in permanent current assets. Guardian also has $500,000 in fixed assets. Assume a tax rate of 40 percent. Construct two alternative financing plans for Guardian. One plan should be conservative, with 75 percent of assets financed by long-term sources, and the other should be aggressive, with only 56.25 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 Guardian’s earnings before interest and taxes are $200,000, calculate earnings after taxes for each of your alternatives. What would happen if the short and long-term rates were reversed?

Paper For Above instruction

The effective management of working capital and asset financing is crucial for corporate financial health, influencing liquidity, profitability, and overall strategic stability. Guardian Inc, with its current asset structure and fixed assets, faces the challenge of devising optimal financing strategies to balance risk and return, especially considering varying interest rates and tax implications. This paper explores two alternative financing plans—conservative and aggressive—for Guardian Inc, evaluates their impact on earnings after taxes, and examines how shifting interest rates could alter outcomes.

The baseline financial data of Guardian Inc provide a clear starting point: total current assets comprise $400,000 in temporary assets and $300,000 in permanent assets, totaling $700,000. Coupled with $500,000 in fixed assets, the total assets amount to $1.2 million. The company’s strategic decision revolves around the proportion of these assets financed through long-term versus short-term sources, influencing risk exposure and cost.

Construction of Financing Plans

The conservative plan aims to finance 75% of total assets using long-term sources. Calculating this, 75% of $1.2 million results in $900,000 financed via long-term debt or equity. The remaining $300,000 is financed through short-term debt or other short-term sources. Conversely, the aggressive plan utilizes a lower proportion, with only 56.25% of assets financed by long-term sources. This equates to approximately $675,000 (56.25% of $1.2 million) financed through long-term means, leaving $525,000 to be financed short-term.

Interest Cost Implications

Interest expenses are derived from the respective rates: 15% for long-term funds and 10% for short-term funds. Under the conservative plan, interest costs are:

• Long-term debt: 15% of $900,000 = $135,000
• Short-term debt: 10% of $300,000 = $30,000

Total interest expense under the conservative plan sums to $165,000 annually.

For the aggressive plan, interest costs are:

• Long-term debt: 15% of $675,000 = $101,250
• Short-term debt: 10% of $525,000 = $52,500

Total interest expense then is $153,750 annually.

Calculation of Earnings After Taxes

Earnings before interest and taxes (EBIT) amount to $200,000, a figure unaffected by financing choices initially. However, interest expenses influence the taxable income. The after-tax earnings are computed as:

Earnings After Taxes (EAT) = (EBIT – Interest Expenses) × (1 – Tax Rate)

For the conservative plan:

Taxable income = $200,000 – $165,000 = $35,000

EAT = $35,000 × (1 – 0.40) = $21,000

For the aggressive plan:

Taxable income = $200,000 – $153,750 = $46,250

EAT = $46,250 × (1 – 0.40) = $27,750

Thus, under the conservative financing plan, Guardian Inc's after-tax earnings amount to $21,000, whereas the aggressive plan yields $27,750.

Impact of Reversing Interest Rates

If interest rates are reversed, with short-term rates increasing to 15% and long-term rates decreasing to 10%, the cost of financing shifts accordingly. Under the conservative plan:

• Long-term debt: 10% of $900,000 = $90,000
• Short-term debt: 15% of $300,000 = $45,000
• Interest expense now becomes $135,000 + $45,000 = $180,000, reducing taxable income and after-tax earnings to:

• Taxable income = $200,000 – $180,000 = $20,000

  EAT = $20,000 × (1 – 0.40) = $12,000

• Similarly, the aggressive plan would see interest costs:
• Long-term debt: 10% of $675,000 = $67,500
• Short-term debt: 15% of $525,000 = $78,750
• Total interest expense is $146,250, leading to:

• Taxable income = $200,000 – $146,250 = $53,750

  EAT = $53,750 × (1 – 0.40) = $32,250

• These shifts demonstrate that higher short-term rates tighten profit margins under the original plans, amplifying the importance of interest rate environment analysis.
• Conclusion
• Constructing optimal financing strategies requires balancing risk appetite with current market conditions. The conservative plan minimizes financial risk by relying more heavily on long-term financing but at a higher fixed cost. The aggressive plan benefits from lower long-term costs but exposes the company to short-term rate fluctuations. The analysis indicates that changes in interest rates substantially influence profitability, emphasizing the importance of flexible financing policies. Guardian Inc's choice between these plans should depend on the stability of interest rates, company risk tolerance, and strategic financial goals.
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