CHAPTER 15 – WORKING CAPITAL AND THE FINANCING DECISION

PROBLEM 1

1. Construct two financing plans – conservative and aggressive.

CONSERVATIVE AGGRESSIVE
Short – term 20% P 240, 000 40% P 480, 000
Long – term 80% 960, 000 60% 720, 000
P 1, 200, 000 P 1, 200, 000

Computation:
Current Assets P 500, 000
Fixed Assets 700, 000
Total Assets P 1, 200, 000

Conservative: Aggressive:
P 1, 200, 000 * .20 = P 240, 000 P 1, 200, 000 * .40 = P 480, 000
P 1, 200, 000 * .80 = P 960, 000 P 1, 200, 000 * .60 = P 720,000

-The total assets is determined by adding the current assets and fixed assets

-Since 80% of the assets on the conservative and 60% on the aggressive are financed by long-
term sources, 20% and 40%, respectively, will be financed by short-term sources. The total
assets will be allocated to long-term and short-term based on their assets percentage.

2. Calculate Net Income under each alternative.

CONSERVATIVE AGGRESSIVE

Earnings before interest and taxes P 325, 000 P 325, 000

Interest:

Short-term – 8.5% ( 20, 400 ) ( 40, 800 )

Long-term – 11% ( 105, 600 ) ( 79, 200 )

Earnings before taxes P 199, 000 P 205, 000

Taxes – 40% ( 79, 600 ) ( 82, 000 )

Net Income P 119, 400 P 123, 000

- Earnings before interest and taxes (EBIT) are stated to be P 325, 000

- Interest is computed by multiplying the interest rate of 8.5% for short-term investments and
11% for long-term investments.

- Earnings before taxes are the difference between EBIT and computed interests.

- Taxes are computed by multiplying the tax rate of 40% to the computed earnings before taxes.

- Net income is the difference between the earnings before taxes and computed taxes.

3. Risks associated with each plan.

Conservative: Effective cost of long-term financing will have the tendency to increase because
the interest rates could significantly drop.

Alternative: Interest rates might increase, in effect, the cost of short-term financing might also
increase that will result to a decrease in net income.

4. Knowing the fact that interest rates aren't fixed and it may differ and fluctuate, the
recommended plan will depend upon the forecasted interest rate.

PROBLEM 2

ALTERNATIVE BALANCE SHEETS

RESTRICTED MODERATE RELAXED

(40%) (50%) (60%)
Current Assets P 1, 200, 000 P 1, 500, 000 P 1, 800, 000
Fixed Assets 600, 000 600, 000 600, 000
Total Assets P 1, 800, 000 P 2, 100, 000 P 2, 400, 000
Debt P 900, 000 P 1, 050, 000 P 1, 200, 000
Equity 900, 000 1, 050, 000 1, 200, 000
Total Liabilities and Equity P 1, 800, 000 P 2, 100, 000 P 2, 400, 000
- Current asset is computed by multiplying the projected sales of P 3,000,000 to the
corresponding ratios of restricted or aggressive (40%), moderate (50%), and conservative
or relaxed (60%) current asset investment policy.
 Restricted or aggressive asset investment policy has fewer liquid assets. Conservative or
relaxed current asset has highest level of liquid assets. Moderate current asset investment
policy lies between the relaxed and restricted policies.

- Fixed asset is stated in the problem as P 600,000.

- Total asset is the sum of current asset and fixed asset.

- Debt is computed by multiplying the corresponding amount of total asset per investment
policy to 50% because it is stated that the debt-to-asset ratio is 50%.

- Total liabilities and equity is equivalent to total assets per investment policy.

- The amount of equity per investment policy is the squeezed difference between the total
liabilities and equity and debt per investment policy.

ALTERNATIVE INCOME STATEMENTS

RESTRICTED MODERATE RELAXED

Sales P 3, 000, 000 P 3, 000, 000 P 3, 000, 000
EBIT 450, 000 450, 000 450, 000
Interest – 10% 90, 000 105, 000 120, 000
Earnings before taxes P 360, 000 P 345, 000 P 330, 000
Taxes – 40% 144, 000 138, 000 132, 000
Net Income P 216, 000 P 207, 000 P 198, 000
ROE 24% 19.7% 16.5%
- Sales is stated to be P 3,000,000.

- Earnings before interest and taxes (EBIT) is computed by multiplying the sales to 15%. It
is stated that the company expects to earn 15% before interest and taxes on sales of P
3,000,000.

- Interest is computed by multiplying the interest rate of 10% to corresponding debt per
investment policy.

- Earnings before taxes is the difference between EBIT and interest per investment policy.
 - Taxes is computed by multiplying the tax rate of 40% to corresponding earnings before
taxes per investment policy.

- Net income is the difference between the earnings before taxes and taxes per investment
policy.

- Return on equity is computed by dividing net income over equity per investment policy.

PROBLEM 3

1. Most Aggressive

Low Liquidity P 2, 000, 000 * 18% = P 360, 000

Short-term Financing 2, 000, 000 * 10% = (200, 000)
Anticipated Return P 160, 000

Multiply the cost of low liquidity plan by its percent of return then add to the product of cost
of short term financing and its corresponding percent of return.

2. Most Conservative

High Liquidity P 2, 000, 000 * 14% = P 280, 000

Long-term Financing 2, 000, 000 * 12% = (240, 000)
Anticipated Return P 40, 000

Multiply the cost of high liquidity plan by its percent of return then add to the product of cost
of long term financing and its corresponding percent of return.

3. Moderate Approach
a. Low Liquidity P 2, 000, 000 * 18% = P 360, 000
Long-term Financing 2, 000, 000 * 12% = (240, 000)
P 120, 000
 b. High Liquidity P 2, 000, 000 * 14% = P 280, 000
Short-term Financing 2, 000, 000 * 10% = (200, 000)
P 80, 000
Multiply the cost of high liquidity plan by its percent of return then add to the product of cost of
short term financing and its corresponding percent of return, or, by multiplying the cost of low liquidity
plan by its percent of return then add to the product of cost of long term financing and its corresponding
percent of return.

4. Plan having the highest return doesn't mean the best choice; we must also consider the risk
corresponding to that plan. Instead we must give more focus what will be the overall effect of
that plan if chosen, considering the return and the risk at the same time.

PROBLEM 4

1. Temporary Current Assets P 300, 000

Permanent Current Assets 200, 000
Fixed Assets 400, 000
Total Assets P 900, 000

Conservative:
Interest Expense
Long-term P 900, 000 * .80 = P 720, 000 * .15 P 108, 000
Short-term P 900, 000 *. 20 = P 180, 000 * .10 18, 000
Total Interest Charge P 126, 000

Alternative:
Interest Expense
Long-term P 900, 000 * .70 = P 270, 000 * .15 P 40, 500
Short-term P 900, 000 *. 30 = P 630, 000 * .10 60, 000
Total Interest Charge P 103, 500

In the conservative approach, 80% of the assets will be financed by the long term sources, so
the total assets of 900,000 are multiplied by 80%. The answer is 720,000 which will be financed
by long term sources and the remaining 180,000 will be financed by short term sources. In
getting the interest expense, 720,000 is multiplied by the rate of 15% and 180,000 multiplied by
10%, the interest expense is 108,000 and 18,000, respectively. The total interest expense is
126,000.

In the aggressive approach, only 30% of the assets will be financed by the long term sources,
so the total assets of 900,000 are multiplied by 30%. The answer is 270,000 which will be
financed by long term sources and the remaining 630,000 will be financed by short term sources.
In getting the interest expense, 270,000 is multiplied by the rate of 15% and 630,000 is
multiplied by 10%, the interest expense is 40,500 and 63,000, respectively. The total interest
expense is 103,500.

2. CONSERVATIVE AGGRESSIVE
EBIT P 180, 000 P 180, 000
Interest (126, 000) (103, 500)
EBT P 54, 000 P 76, 500
Tax – 40% (21, 600) (30, 600)
Earnings after tax P 32, 400 P 45, 900

The interest expense of 126,000 and 103,500 is deducted each to 180,000. So the
earnings before taxes will be 54,000 for conservative approach and 76,500 for aggressive
approach. To get the earnings after taxes, 54,000 and 76,500 are each multiplied by 60%, which
is 100% less tax rate of 40%. So the earnings after tax for conservative approach is 32,400 and
for aggressive approach is 45,900.

PROBLEM 5

1. Current Assets P 800, 000

Permanent Current Assets (350, 000)
Temporary Current Assets P 450, 000

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

= P 775, 000 * 10%
= P 77, 500
 Short-term interest expense = [P 450, 000 + ½ (P 350, 000)] * 5%
= P 625, 000 * 5%
= P 31, 250

Total interest expense = P 77, 500 + P 31, 250

= P 108, 750

Earnings before interest and taxes P 200, 000

Interest expense (108, 750)
Earnings before taxes P 91, 250
Taxes – 30% (27, 375)
Earnings after taxes P 63, 875

To get the total assets financed by long term debt, add 600 000 from fixed assets and half of
P350,000, which is P175,000, from permanent current assets then multiply it by 10% to get the
long term debt interest. The other half of permanent current asset will be added to the temporary
current asset, which is the difference between the current asset and the permanent current asset,
then multiply it by 5% to get the short term debt interest. Combine the two interests then subtract
it by the earnings before income tax worth P200,000 to get the earnings after interest but before
tax. Deduct the 30 % tax to come up with earnings after tax.

2. Long-term interest expense = [P 600, 000 + (P 350, 000) + ½ (P 450, 000)] * 10%
= P 1, 775, 000 * 10%
= P 177, 500

Short-term interest expense = [½ (P 450, 000)] * 5%

= P 225, 000 * 5%
= P 11, 250

Total interest expense = P 177, 500 + P 11, 250

= P 128, 750
 Earnings before interest and taxes P 200, 000
Interest expense (128, 750)
Earnings before taxes P 71, 250
Taxes – 30% (21, 375)
Earnings after taxes P 49, 875

To get the asset financed by long term debt, add the P600,000, which is from fixed asset,
P350,000 from permanent current assets and half of temporary current asset computed on the
previous number which is P225,000 then multiply it by 10% to get the long term debt interest.
The other half of temporary current asset will be multiplied by 5% to get the short term debt
interest. Combine the two interests then subtract it by the earnings before interest worth
P200,000 to get the earnings after interest but before tax. Deduct the 30 % tax to come up with
earnings after income tax.

3. The first alternative is more risky because there is an extensive use of short term debt
which leads to huge payments of interest but great amount of expected return. In cases of
emergency, this will result to the insufficiency of cash on hand and will not be able to
make interest payments.
On the other hand, the second alternative is less risky because there are only few
short term debts incurred. In this alternative, you will have more cash on hand but will
result to smaller profit because of improper usage of working capital.

SUBMITTED BY:

Aure, Lea Angelene D.

Cruz, Tenessee Angelica Blue L.

Eyana, Julie P.

Ildefonso, Divine

Villazor, Mary Charlotte

Zapico, Carrina Claryse P.