Firm A has $20,000 in assets entirely financed with equity.

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.

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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 for both firms (i.e. what is the income after deducting operating expenses, but before deducting expenses for interest or taxes)?

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)

For parts (d) – (e) 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?