Question

Nighthawk Steel, a manufacturer of specialized tools, has $5,520,000 in assets. Temporary current assets $1,340,000 Permanent current assets 1,840,000 Capital assets 2,340,000 Total assets $5,520,000 Short-term rates are 5 percent. Long-term rates are 7.5 percent. (Note that long‐term rates imply a return to any equity). Earnings before interest and taxes are $1,130,000. The tax rate is 25 percent. Assume the term structure of interest rates becomes inverted, with short-term rates going to 10 percent and long-term rates 5 percentage points lower than short-term rates. 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 be after taxes?

Answer 1

To calculate the earnings after taxes, we need to consider the change in interest rates, the impact on short-term financing, and subtract the interest expense from the EBIT to find the earnings before taxes. The tax rate is 25 percent, so we multiply the earnings before taxes by 0.75 to find the earnings after taxes.

Step-by-step explanation:

To calculate the earnings after taxes in this scenario, we need to consider the change in interest rates and the impact on the firm's finances. Since the long-term financing is perfectly matched with long-term asset needs, it is not affected by the change in interest rates. However, the short-term financing is affected. Initially, the short-term rates are 5 percent, but they increase to 10 percent in the inverted term structure.

The earnings before interest and taxes (EBIT) for the firm are $1,130,000. To calculate the earnings after taxes, we first need to calculate the interest expense. The interest expense from the short-term financing can be calculated by multiplying the short-term rate (10 percent) by the temporary current assets ($1,340,000). The interest expense from the long-term financing is zero since it is perfectly matched (hedged) with long-term assets.

Next, we subtract the interest expense from the EBIT to find the earnings before taxes. The tax rate is 25 percent, so we multiply the earnings before taxes by 0.75 to find the earnings after taxes. Using these calculations, we can determine the earnings after taxes given the change in interest rates.