Fin 370 –Individual Assignment Week Five

FIN 370 –Individual Assignment Week Five

Chapter 20Problem 1

1. Firm A has $10,000 in assets entirely financed with equity. Firm B also has $10,000 in assets, but these assets are financed by $5,000 in debt (with a 10 percent rate of interest) and $5,000 in equity. Both firms sell 10,000 units of output at $2.50 per unit. The variable costs of production are $1, and fixed production costs are $12,000. (To ease the calculation, assume no income tax.)

a. What is the operating income (EBIT) for both firms?

Sales Revenue = $10,000 x $2.50 = $25,000

less variable cost = 10,000 x $1 = $10,000

less fixed cost = $12,000

EBIT = $3,000

B. What are the earnings after interest?

FIRM A FIRM B

Interest = $0. EBIT = $3,000

Earnings after interest = EBIT = $3,000 Less interest on debt = $5,000 x .10 = $500

Earning after interest = $2,500

C. If sales increase by 10 percent to 11,000 units, by what percentage will each firm’s earnings after interest increase? To answer the question, determine the earnings after taxes and compute the percentage increase in these earnings from the answers you derived in part b.

Sales Revenue = 10,000 x 1.1 x $2.50 = $27,500

less variable cost = 10.000 x 1.1 x $1 = $11,000

less fixed cost= $12,000

EBIT= $4,500

FIRM A FIRM B

Interest = $0 EBIT = $4,500

Earnings after interest = $4,500 Less interest = $5000 x 10% = $500

% increase = (4500-3000)3000x100%Earnings after interest = $4,000

= 50%% increase = (4000-2500)2500x100%

= 60%

D. Why are the percentage changes different?

Changes inpercentagesare different becausethere was an...