Chapter 6, Problem 10P

Assume that Hogan Surgical Instruments Co. has $\text{\$2,500,000}$ in assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 18 percent, but with a high-liquidity plan, the return will be 14 percent. If the firm goes with a short-term financing plan, the financing costs on the $\text{\$2,500,000}$ will be 10 percent, and with a long-term financing plan, the financing costs on the $\text{\$2,500,000}$ will be 12 percent. (Review Table 6-11 for parts a, b, and c of this problem.)

a. Compute the anticipated return after financing costs with the most aggressive asset financing mix.

b. Compute the anticipated return after financing costs with the most conservative asset financing mix.

c. Compute the anticipated return after financing costs with the two moderate approaches to the asset financing mix.

d. Would you necessarily accept the plan with the highest return after financing costs? Briefly explain.

Summary Introduction

To calculate: The anticipated return, after deducting the finance costs, with the most aggressive approach of the asset financing mix.

Introduction:

Anticipated return:

It is the amount that an individual or company has estimated to earn from an investment. It is one of the factors taken into account by an investor before selecting an investment plan.

Aggressive approach:

When a company selects a plan of low liquidity with high return and long-term financing, it is termed as an aggressive approach.

Answer to Problem 10P

The anticipated return, after deducting the finance costs, with the most aggressive asset financing mix approach is $200,000.

Explanation of Solution

The calculation of the anticipated return is as follows.

$\begin{array}{c}\text{Anticipated Return}=\text{Return from Low-Liquidity Plan}-\text{Finance Cost of Short-Term Finance}\\ =\$450,000-\$250,000\\ =\$200,000\end{array}$

Working notes:

The calculation of the return from the low liquidity plan is as follows.

$\begin{array}{c}\text{Return}=\text{Assets Cost}\times \text{Rate of Return}\\ =\$2,500,000\times 18\%\\ =\$450,000\end{array}$

The calculation of the finance cost of short-term financing is as follows.

$\begin{array}{c}\text{Finance Cost}=\text{Assets Cost}\times \text{Interest Rate}\\ =\$2,500,000\times 10\%\\ =\$250,000\end{array}$

Summary Introduction

To calculate: The anticipated return, after deducting the finance costs, with the most conservative approach of the asset financing mix.

Introduction:

Conservative approach:

When a company selects a plan of high-liquidity with low return and short-term financing, it is termed as a conservative approach.

Answer to Problem 10P

The anticipated return, after deducting the finance costs, with the most conservative asset financing mix approach is $50,000.

Explanation of Solution

The calculation of the anticipated return is as follows.

$\begin{array}{c}\text{Anticipated Return}=\text{Return from High-Liquidity Plan}-\text{Finance Cost of Long-Term Finance}\\ =\$350,000-\$300,000\\ =\$50,000\end{array}$

Working notes:

The calculation of the return from the high liquidity plan is as follows.

$\begin{array}{c}\text{Return}=\text{Assets Cost}\times \text{Rate of Return}\\ =\$2,500,000\times 14\%\\ =\$350,000\end{array}$

The calculation of the finance cost of the long-term finance is as follows:

$\begin{array}{c}\text{Finance Cost}=\text{Assets Cost}\times \text{Interest Rate}\\ =\$2,500,000\times 12\%\\ =\$300,000\end{array}$

Summary Introduction

To calculate: The anticipated return, after deducting the finance costs with the two moderate approaches of the asset financing mix.

Introduction:

Moderate approach:

When a company selects a plan of low liquidity with high return and short-term financing or one of high liquidity with low return and long-term financing, it is termed as a moderate approach.

Answer to Problem 10P

The anticipated return, after deducting the finance costs, with the moderate approach of the low liquidity plan and long-term financing of the asset financing mix is $150,000.

The anticipated return, after deducting the finance costs, with the moderate approach of the high liquidity plan and short-term financing of the asset financing mix is $100,000.

Explanation of Solution

Anticipated return in the moderate approach of the low liquidity plan and long-term financing of asset financing mix:

The calculation of the anticipated return is as follows.

$\begin{array}{c}\text{Anticipated Return}=\text{Return from Low-Liquidity Plan}-\text{Finance Cost of Long-Term Finance}\\ =\$450,000-\$300,000\\ =\$150,000\end{array}$

Working notes:

The calculation of the return from the low liquidity plan is as follows.

$\begin{array}{c}\text{Return}=\text{Assets Cost}\times \text{Rate of Return}\\ =\$2,500,000\times 18\%\\ =\$450,000\end{array}$

The calculation of the finance costs of long-term financing is as follows.

$\begin{array}{c}\text{Finance Cost}=\text{Assets Cost}\times \text{Interest Rate}\\ =\$2,500,000\times 12\%\\ =\$300,000\end{array}$

Anticipated return in the moderate approach of the high liquidity plan and short-term financing of the asset financing mix:

The calculation of the anticipated return is as follows.

$\begin{array}{c}\text{Anticipated Return}=\text{Return from High-Liquidity Plan}-\text{Finance Cost of Short-Term Finance}\\ =\$350,000-\$250,000\\ =\$100,000\end{array}$

Working notes:

The calculation of the return from the high-liquidity plan is as follows.

$\begin{array}{c}\text{Return}=\text{Assets Cost}\times \text{Rate of Return}\\ =\$2,500,000\times 14\%\\ =\$350,000\end{array}$

The calculation of the finance costs of short-term financing is as follows.

$\begin{array}{c}\text{Finance Cost}=\text{Assets Cost}\times \text{Interest Rate}\\ =\$2,500,000\times 10\%\\ =\$250,000\end{array}$

Summary Introduction

To explain: Whether the plan with highest return after deducting the financing cost shall be accepted.

Introduction:

Finance Cost:

It is the cost that a company incurs to raise finance through debt or borrowed funds. Examples of borrowing costs are the interests paid on a loan (both short term and long term), the financial charges for finance leases, etc.

Answer to Problem 10P

No, it is not necessary to accept the plan that has high returns even after deducting the finance costs because risk also has to be taken into consideration while making the decision.

Explanation of Solution

The decision of selecting a plan does not only depend on the returns but also on its risk. High return is usually earned by taking high risks, but certain companies are not able to take such risks, which is why they choose a plan that has an average risk with average returns.