Individual Assignment: Financing Strategy Problems
Week 5
FIN/370
Mr. Robert Risk
Financing Strategy Problems
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 as $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
Variable Cost = 10,000 X $1.00 = $10,000
Fixed Cost = $12,000
EBIT = Sales Revenue – Variable Cost – Fixed Costs
EBIT = $3,000
B) What are the earnings after interest?
Firm A : $0 interest earned
Firm A earnings after interest = $3,000 ($3,000 – 0 = $3,000)
Firm B: $500 interest earned ($5,000 X 10% = $500)
Firm B earnings after interest = $2,500 ($3,000 - $500 = $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 = $11,000 X $2.50 = $27,500
Variable Cost = $11,000 X $1.00 = $11,000
Fixed Costs = $12,000
EBIT = Sales Revenue – Variable Cost – Fixed Costs
EBIT = $4,500
Firm A : $0 interest earned
Firm A earnings after interest = $4,500 ($4,500 – 0 = $4,500)
Firm A percentage increase = 50% [(4,500-3,000)/3000 X 10% = 50%]
Firm B: $500 interest earned ($5,000 X 10% = $500)
Firm B earnings after interest = $4,000 ($4,500 - $500 = $4,000)
Firm B percentage increase = 60% [(4,000-2,500)/2500 X 10% = 60%]
C) Why are the percentage changes different?
The difference in percentage changes is solely based on the amount of interest earned. Even though it looks like Firm A...