Posted by John on Monday, March 12, 2012 at 11:51am.
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 is the operating income (EBIT) for both firms?
EBIT = 10000 * 2.5 – 10000 * 1 – 12000 = $3000
b. What are the earnings after interest?
Earnings after interest (Firm A) = $3000 - 0 = $3000
Earnings after interest (Firm B) = $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.
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)/2500 = 60%
d. Why are the percentage changes different?
The percentage changes are different because of the different capital structure between the two firms.
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