Fin 370 Chap 20 Week 5 Problems

Financing Problems # 1 Ch 20

FIN 370

June 25, 2012

Derek Webster

Fin Strategy Problems # 1 Ch 20 (Wk 5)

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?

$3000

(Sales $10000 x 2.50-Variable Costs $10000 x 1 -Fixed Costs $12000= $3000)

B) What are the earnings after interest?

Firm A: $0 interest earned

Earnings after interest= $3000 ($3000 – 0= $3000)

Firm B $500 interest earned = $5000 x 10% = $500

Earnings after interest = $2500 ($3000-$500 = $2500)

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.

EBIT $4500

(Sales $11000 x 2.50 – Variable Costs $11000 x 1 – Fixed Cost $12000= $4500)

Firm A: $0 interest earned

Earnings after taxes $4500 = ($4500 – 0= $4500)

Percentage increase= 50% = (4500-3000)/3000x10=50%

Firm B: $500 interest earned = ($5000 x 10%= $500)

Earnings after taxes $4000 = ($4500 - $500=$4000)

Percentage increase= 60% = ($4000-$2500)/$2500 = 60%

D) Why are the percentage changes different?

The differences in the percentages are different because of the difference in the earnings after taxes and the earnings after interest between Firm A and Firm B.

This data proves which firm has a more favorable financial advantage.