Financing Strategy Problems

In: Business and Management

Submitted By Aguillet
Words 256
Pages 2
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 = 10000*2.5=25000
Variable cost = 10000*1=10000
Fixed cost = 12000

EBIT=25000-10000-12000=3000

B. What are the earnings after interest?
Firm A Interest=0
Firm B Interest= 5000*10%=500
Earnings after interest for Firm A = $3000 - 0 = $3000
Earnings after interest for Firm B = $3000 – 500 = $2500 C. If Sales increase by 10% to 11,000 units, by what percentage will each firm’s earnings after interest increase? To answer the questions determine the earnings after taxes and compute the percentage increase in these earnings from the answer you derived in Part B.
New EBIT (Both Firms) = 11000 * 2.5 – 11000 * 1 – 12000 = $4500
New Earnings after interest (Firm A) = $4500 – 0 = $4500
New Earnings after interest (Firm B) = $4500 – 500 = $4000

Increase in Firm A Earnings = (4500 – 3000)/3000 = 50%
Increase in Firm B Earnings = (4000 – 2500)/2500 = 60%

D. Why are the percentage changes different?
The percentage changes are different because of the different capital structure between the two…...

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