Hello Kitty Kat House is developing an asset financing plan

Hello Kitty Kat House is developing an asset financing plan.  Kitty has $500,000 in current assets, of which 15% are permanent, and $700,000 in fixed assets. The current long-term rate is 11%, and the current short-term rate is 8.5%. Kitty\'s tax rate is 40%.
           
            Construct two financing plans--one conservative, with 80% of assets financed by long-term sources, and the other aggressive, with only 60% of assets financed by long-term sources.

If Kitty\'s earnings before interest and taxes are $325,000, calculate net income under each alternative.
           

A. A)   Plan A $123,000 Plan B   $119,000            

B. B)   Plan A $132,000 Plan B   $123,500            

C. C)  Plan A $19,000 Plan B     $26,000            

D. D)   Plan A $119,000 Plan B   $123,000

Solution

Total Assets = Fixed Assets + Current Assets = 500,000 + 700,000 = 1,200,000

Conservative Plan - Plan A

80% Long term financing and 20% short term financing

Interest expense for long term financing = 80% * 1,200,000 * 11% = 105,600

Interest expense for short term financing = 20% * 1,200,000 * 8.5% = 20,400

Net Income = [EBIT - Interest Expense] * (1 - Tax rate)

Net Income = [325,000 - 126000] * (1 - 40%) = 119,400

Aggressive Plan - Plan B

60% Long term financing and 40% short term financing

Interest expense for long term financing = 60% * 1,200,000 * 11% = 79200

Interest expense for short term financing = 40% * 1,200,000 * 8.5% = 40800

Net Income = [EBIT - Interest Expense] * (1 - Tax rate)

Net Income = [325,000 - 120000] * (1 - 40%) = 123,000

Hence, Option D is the closest and that is the answer