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Resource: Chapter 20, Mayo, H. B. (2012). Basic
finance: An introduction to financial institutions, investments,
and management (9th ed.). Mason, OH: Thomson.
Firm A 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 income 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 the increased sales, what is the percentage
increase in earnings after interest for each firm?
f. Which firm had the higher increase in earnings, and why?
g. What is each firm’s Return on Equity with the increased
sales?
h. Why might investors prefer to invest in the firm that
provides lower total earnings?
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