Financing Strategy Assignment

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Financing Strategy Assignment
The following is a response to problem 1 in chapter 20 of Basic Finance: 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.) 1. What is the operating income (EBIT) for both firms?

The operating income or “earnings before interest and taxes (EBIT) for both firms are: EBIT – 10,000 * 2.5 – 10,000 * 1 – 12,000 = $3,000

2. What are the earnings after interest?
Firm A’s Earning s after interest = $3000 – 0 = $30000
Firm B’s Earnings after interest = $3000 – 500 = $2,500

3. 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. New EBIT (Both Firms) = 11000 * 2.5 – 11000 * 1 – 12000 = $4500 New Earnings after interest (Firm A) = $4500 – 0 = $4500

New Earnings after interest (Firm B) = $4500 – 500 = $4000

Increase in Firm A Earnings = (4500 – 3000)/3000 = 50%
Increase in Firm B Earnings = (4000 – 2500)/1500 = 60%
4. Why are the percentage changes different?
The percent changes are different because of the different because of the different capital structure between the two firms. The second firm, (firm B), was able to use other people’s money in order to operate the business, making better use of the monies available to them.
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