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: 12000

EBIT = sales/revenue – variable cost – fixed production cost = 25000 – 10000 – 12000 = $3000

B. What are the earnings after interest?

Interest Earnings 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 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: 11000 * 2.50 = 27500 Variable Cost: 11000 * 1 = 11000 Fixed Production Cost: 12000

EBIT = sales/revenue – variable cost – fixed production cost = 27500 – 11000 – 12000 = 4500

Firm A Firm B

Interest 0 5000 * 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