Fin 370

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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...
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