The following structure of interest rates is given:
Term of Loan Interest Rate
1 year....... 3%
2 years....... 4%
5 years....... 6%
10 years....... 8%
Your firm needs $2,000 to finance its assets. Three possible combinations of sources of finance are listed below:

a. The firm expects to generate revenues of $2,400 and have operating expenses of $2,080. If the firm€™s tax rate is 40 percent, what is the return on equity under each choice?
b. During the second year, sales decline to $2,100 while operating expenses decline to $1,900. The structure of interest rates becomes:
Term of Loan Interest Rate
1 year........ 6%
2 years........ 7%
5 years........ 8%
10 years........ 10%
c. Given the three choices in the previous year, what is the return on equity for the firm during the second year?
d. What is the implication of using short-term instead of long-term debt during the two years?

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Assets $2,000 Liabilities0 Assets $2,000 Liabilities 800 (a one-year loan) 1,200 Equity 2,000 Equity Assets $2,000 Liabilities 800 (a 10-year loan) Equity 1,200