Chapter 20 Problem 1

Week 5 – Financing Strategy Problem Problem 1 – Chapter 20 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 if the operating income (EBIT) for both firms? Sales/Revenue: 10000 * 2. 50 = 25000 Variable Cost: 10000 * 1 = 10000 Fixed Production Cost: 12000EBIT = sales/revenue – variable cost – fixed production cost = 25000 – 10000 – 12000 = $3000 B. What are the earnings after interest? InterestEarnings after interest Firm A: 0 3000 – 0 = $3000 Firm B:5000 * 10% = 500 3000 – 500 = $2500 C. If sales increase by 10 percent to 11,000 units, by what percentage will each firm’s earning s 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: 11000 * 2. 50 = 27500 Variable Cost: 11000 * 1 = 11000Fixed Production Cost: 12000 EBIT = sales/revenue – variable cost – fixed production cost = 27500 – 11000 – 12000 = 4500 Firm A Firm B Interest 05000 * 10% = 500 Earnings after interest (prior) 3000 – 0 = 3000 3000 – 500 = 2500 Earnings after interest (after) 4500 – 0 = 4500 4500 – 500 = 4000 Increase/decrease % 50% 60% D. Why are the percentage changes different? Firm B had a higher increase in profit because they had a higher net % change and lowered their interest income through their debt financing.