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- Date Submitted: 06/12/2013 12:00 PM
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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...

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