Wk 5 Study Problem Fin/370

Elizabeth Zander
CHAPTER 20
Problem # 1 page 397
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.)
Firm A
Assets
10,000 Firm B
Assets
10,000
$5,000 in debt at 10%
$5,000 in equity Both Firm A and Firm B- sell 10,000 units @ 2.50
Variable cost- $1
Fixed Cost- $12,000
a. What is the operating income (EBIT) for both firms?
Firm A
EBIT = Revenue - Operating Expenses = $2.50*10,000 - $1*10000 - $12,000 = $3,000 Firm B
EBIT = Revenue - Operating Expenses = $2.50*10,000 - $1*10000 - $12,000 = $3,000

b. What are the earnings after interest?
The earnings after Interest are:
Firm A
$3,000-$0=$3,000
Firm B
$3,000-10%*$5,000=$3,000-$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.
New Sales = 11000
Firm A
EBIT = Revenue - Operating Expenses = $2.50*11,000 - $1*11000 - $12,000 = $4,500
Earnings After Interest = $4,500
Percentage Increase = ($4,500 - $3,000)/$3,000 = 50%
Firm B
EBIT = Revenue - Operating Expenses = $2.50*11,000 - $1*11000 - $12,000 = $4,500
Earning After Interest = $4,500 - $500 = $4,000
Percentage Increase = ($4,000 - $2,500)/$2,500 = 60% d. Why are the percentage changes different?
The percentage changes are different because Firm A is getting an increase of $1,500 in revenues over the earlier value $3,000
Firm B is getting an increase of $1,500 in revenues over the earlier value $2,500
This is the same increase, but original