Why might investors prefer to invest in the firm that
provides lower total earnings?
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
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
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
h. Why might investors prefer to invest in the firm that
provides lower total earnings?
All Finance Questions Solution In Excel File
3. How many years would it take $50
to triple if you invested it in a bank that
pays 8.25% per year?
4. You want to buy a new sports car 4 years from now, and you
plan to save $4,400 per year,beginning immediately.
You will make 4 deposits in an account that pays 5.75% interest.
Under these assumptions, how much will you have 3 years from
5. What’s the present value of a 5-year ordinary annuity of
$2,250 per year plus an additional $3,500 at the end of Year 5 if
the interest rate is 6%?
6. What’s the future value of $2,500 after 5 years if the
appropriate interest rate is 7.5%, compounded semiannually?
7. An investment promises the following cash flow stream: $1500
at Time 0; $2,750 at the end of Year 1 (or at t = 1); $3,150 at the
end of Year 2; and $4,800 at the end of Year 3. At a discount rate
of 10.0%, what is the present value of the cash flow stream?
8. Suppose you are buying your first house for $250,000, and are
making a $50,000 down payment. You have arranged to finance the
remaining amount with a 10-year, monthly payment, amortized
mortgage at a 3.4% nominal interest rate. What will your equal
monthly payments be?
9. You plan to borrow $30,000 at an 8% annual interest rate. The
terms require you to amortize the loan with 10 equal end-of-year
payments. How much interest would you be paying in Year 4?
10. You just deposited $4,000 in a bank account that pays a 6%
nominal interest rate, compounded quarterly. If you also add
another $9,000 to the account one year (12 months) from now and
another $7,500 to the account two years from now, how much will be
in the account three years (12 quarters) from now?
11. Your sister turned 35 today, and she is planning to
save $6,000 per year for retirement, with the first deposit to be
made one year from today. She will invest in a mutual fund that
will provide a return of 8.5% per year. She plans to retire 30
years from today, when she turns 65, and she expects to live for 25
years after retirement, to age 90. Under these assumptions, how
much can she spend in each year after she retires? Her first
withdrawal will be made at the beginning of
her first retirement year.
12. You anticipate that you will need $2,000,000 when you retire
40 years from now. You plan to make 40 deposits, beginning today,
in a bank account that will pay 7% interest, compounded annually.
You expect to receive annual raises of 4%, so you will increase the
amount you deposit each year by 4%. (That is, your 2nd deposit will
be 4% greater than your first, the 3rd will be 4% greater than the
2nd, etc.) How much must your 1st deposit be if you are to meet
14. Medium Size Retailers, Inc. (MSR) has EBIT of $225,000,
interest expense of $30,000, dividend income of $15,000, short term
capital gains of $15,000, and long term capital losses of $18,000.
What is MSR’s income tax liability?
15. Frederickson Office Supplies recently reported $12,500 of
sales, $7,250 of operating costs other than depreciation, and
$1,750 of depreciation. The company had no amortization charges and
no non-operating income. It had $8,000 of bonds outstanding that
carry a 9.0% interest rate, and its federal-plus-state income tax
rate was 40%. How much was the firm’s taxable income, or earnings
before taxes (EBT)?
16. Over the years, Janjigian Corporation’s stockholders have
provided $19,250 of capital, part when they purchased new issues of
stock and part when they allowed management to retain some of the
firm’s earnings. The firm now has 1,500 shares of common stock
outstanding, and it sells at a price of $48.00 per share. How much
value has Janjigian’s management added to stockholder wealth over
the years, i.e., what is Janjigian’s MVA?
18. HHH Inc. reported $14,500 of sales and $7,025 of
operating costs (including depreciation). The company had $18,750
of investor-supplied operating assets (or capital), the weighted
average cost of that capital (the WACC) was 9.5%, and the
federal-plus-state income tax rate was 35%. What was HHH’s Economic
Value Added (EVA), i.e., how much value did management add to
stockholders’ wealth during the year?