FIN 370 Week 5 chapter 20 problem 1

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?

b. What are the earnings after interest?

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.

d. Why are the percentage changes different?