# Fin370 Week 5 Financing Strategy Problem

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Financing Strategy Problem Week 5 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.) Response: a. What is the operating income (EBIT) for both firms? EBIT = (Sales Revenue - Variable Cost - Fixed Cost) = \$10,000 x \$2.50 = \$25,000 = 10,000 x \$1 = \$10,000 = \$12,000 = \$25,000 - \$10,000 - \$12,000 EBIT = \$3,000 b. What are the earnings after interest? Earnings after interest = (EBIT - Interest on debt) Interest = \$0 EBIT = \$3,000 = \$3,000 – (\$5,000 x 0.10) = \$3,000 - \$500 = \$2,500 (Earnings after interest) Firm A Firm B \$2,500 \$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. EBIT = (Sales Revenue - Variable Cost - Fixed Cost) = 10,000 x (1.1 x \$2.50) = \$27,500 = 10,000 x (1.1 x \$1) = \$11,000 = \$12,000 EBIT = \$4,500 (\$27,500 - \$11,000 - \$12,000) Earnings after interest = (EBIT - Interest on debt) Interest = \$0 EBIT = \$4,500 = \$4,500 – (\$5000 x 0.10) = \$4,500 - \$500 (Less interest) = \$4,000 (Earnings after interest) = \$4,500 - \$3000 / (3000 x 100%) Firm A Firm B = (4000 - 2500) x (2500 x 100%) 50% increase = 60% (Earnings after interest % increase percentage) d. Why are the percentage changes different? The percentage increased in earnings based on the higher taxes Firm B acquired from its financed debt. What happened is the firm’s profits were reduced by