Financial Leverage Problem
A Firm 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 tax)
a. What is the operating income (EBIT) for both firms?
b. What are the earnings after interest for each firm?
c. What is each firm’s return on equity? (Calculate ROE based on earnings after interest….assume no income tax.)
Assume sales increase by 10% (to 33,000 units)
d. What are the earnings after interest for each firm with the increased sales?
e. With increased sales, what is the percentage increase in earnings after interest for each firm?
f. Why are the percentage changes to earnings after interest different?
g. What is each firm’s Return on Equity with increased sales?
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