Firm A has $10,800 in assets entirely financed with equity. Firm B also has $10,800 in assets, but these assets are financed by $5,400 in debt (with a 15 percent rate of interest) and $5,400 in equity. Both firms sell 11,000 units of output at $3.00 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? Round your answers to the nearest dollar. b. What are the earnings after interest? Round your answers to the nearest dollar. c. If sales increase by 15 percent to 12,650 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. Round your answers to one decimal place.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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