# Chapter 20 Problem 1

**Topics:**Generally Accepted Accounting Principles, Cost, Income

**Pages:**2 (285 words)

**Published:**November 16, 2012

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?

InterestEarnings 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 05000 * 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 financing.

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