Question

A financial manager is considering two possible sources of funds necessary to finance a $10,000,000 investment that will yield $1,500,000 before interest and taxes. Alternative one is a short-term commercial bank loan with an interest rate of 8 percent for one year. The alternative is a five-year term loan with an interest rate of 10 percent. The firm's income tax rate is 30 percent.

Required:
a. What will be the firm's projected earnings under each alternative for the first year?
b. The financial manager expects short-term rates to rise to 11 percent in the second year. At that time long-term rates will have risen to 12%. What will be the firm's projected earnings under each alternative in the second year?
c. What are the crucial considerations when selecting between short- and long-term sources of finance?

Answer 1

a. We have:

Firm's projected earnings under short-term loan for the first year = $490,000

Firm's projected earnings under long-term loan for the first year = $350,000

b. We have:

Firm's projected earnings under short-term loan for the second year = $280,000

Firm's projected earnings under long-term loan for the second year = $210,000

c. These include repayment terms, security available, the total cost of borrowing, business risk, the current capital gearing of the business, and among others.

Step-by-step explanation:

a. What will be the firm's projected earnings under each alternative for the first year?

Firm's projected earnings under short-term loan for the first year = Investment yield - (Amount Borrowed * Short-term interest rate in the first year) - (((Investment yield - (Amount Borrowed * Short-term interest rate in the first year)) * Tax rate) = $1,500,000 - ($10,000,000 * 8%) - ((($1,500,000 - ($10,000,000 * 8%)) * 30%) = $490,000

Firm's projected earnings under long-term loan for the first year = Investment yield - (Amount Borrowed * Long-term interest rate in the first year) - (((Investment yield - (Amount Borrowed * Long-term interest rate in the first year)) * Tax rate) = $1,500,000 - ($10,000,000 * 10%) - ((($1,500,000 - ($10,000,000 * 10%)) * 30%) = $350,000

b. The financial manager expects short-term rates to rise to 11 percent in the second year. At that time long-term rates will have risen to 12%. What will be the firm's projected earnings under each alternative in the second year?

Firm's projected earnings under short-term loan for the second year = Investment yield - (Amount Borrowed * Short-term interest rate in the second year) - (((Investment yield - (Amount Borrowed * Short-term interest rate in the second year)) * Tax rate) = $1,500,000 - ($10,000,000 * 11%) - ((($1,500,000 - ($10,000,000 * 11%)) * 30%) = $280,000

Firm's projected earnings under long-term loan for the second year = Investment yield - (Amount Borrowed * Long-term interest rate in the second year) - (((Investment yield - (Amount Borrowed * Long-term interest rate in the second year)) * Tax rate) = $1,500,000 - ($10,000,000 * 12%) - ((($1,500,000 - ($10,000,000 * 12%)) * 30%) = $210,000

c. What are the crucial considerations when selecting between short- and long-term sources of finance?

The crucial considerations when selecting between short- and long-term sources of finance include repayment terms, security available, the total cost of borrowing, business risk, the current capital gearing of the business, and among others.