# Fin 370

Only available on StudyMode
• Download(s) : 60
• Published : March 3, 2013

Text Preview
Financial Leverage Problem – due Mon March 4, 2013

Resource: Chapter 20, Mayo, H. B. (2012). Basic finance: An introduction to financial institutions, investments, and management (9th ed.). Mason, OH: Thomson.

Firm A has \$20,000 in assets entirely financed with equity.
Firm B also has \$20,000 in assets, financed by \$10,000 in debt (with a 10 percent rate of interest) and \$10,000 in equity.

Both firms sell 30,000 units at a sale price of \$4.00 per unit. The variable costs of production are \$3 per unit.
Fixed production costs are \$25,000.
(assume no income tax.)

a.What is the operating income (EBIT) for both firms?
Sales revenue for both firms= \$120,000
Variable cost for both firms= \$90,000
Fixed costs for both firms= \$25,000
EBIT= 120,000-90,000-25,000
For both firms the EBIT is \$5,000

b.What are the earnings after interest for each firm?
Firm A: Interest=0 So Earnings after tax=\$5,000
Firm B: Interest=10,000X.10 Means Earnings after tax=\$4,000

c.What is each firm’s Return on Equity? (calculate ROE based on earnings after interest … assume no income tax) Firm A: \$5,000/\$20,000=25%
Firm B: \$4,000/\$20,000=20%

Assume sales increase by 10% (to 33,000 units)

d. What are the earnings after interest for each firm with the increased sales? Sales revenue for both firms=\$132,000
Variable cost for both firms=\$99,000
Fixed costs for both firms= \$25,000
EBIT=132,000-99,000-25,000
EBIT=\$8,000
Firm A: Interest=0, Earnings after tax=\$8,000
Firm B: Interest=10,000x.10=1000=\$7,000

e.With the increased sales, what is the percentage increase in earnings after interest for each firm? Firm A: The % increase in earnings after interest=8000-5000/5000=60% Firm B: The % increase in earnings after interest=7000-4000/4000=75%

f.Which firm had the higher increase in earnings, and why?
Firm B had the higher increase in earnings. The assets for Firm B were separated into 10,000 equity and 10,000 in debt

g. What is each firm’s...