Question

Hicks health clubs, incorporated expects to generate an annual ebit of $511,000 and needs to obtain financing for $1,040,000 of assets. its tax bracket is 35%. if the firm uses short-term debt, its rate will be 7.0%, and if it uses long-term debt, its rate will be 8.0%. by how much will their earnings after taxes change if they choose the more aggressive financing plan instead of the more conservative plan?

Answer 1

The change in earnings after taxes can be calculated by subtracting the taxes paid under the aggressive financing plan from the taxes paid under the conservative financing plan. Under the aggressive plan, the firm's earnings before taxes (EBT) will be $511,000 and the taxes paid will be $178,850. Under the conservative plan, the taxes paid will be $153,370. The change in earnings after taxes will be -$25,480.

Step-by-step explanation:

The change in earnings after taxes can be calculated by subtracting the taxes paid under the aggressive financing plan from the taxes paid under the conservative financing plan.

Under the aggressive plan, the firm's earnings before taxes (EBT) will be the same as the EBIT, which is $511,000. The taxes paid under the aggressive plan will be equal to 35% of the EBT, which is $511,000 * 0.35 = $178,850.

Under the conservative plan, the firm's interest expense will be calculated based on the short-term debt rate of 7%, which is $1,040,000 * 0.07 = $72,800. The EBT under the conservative plan will be $511,000 - $72,800 = $438,200. The taxes paid under the conservative plan will be equal to 35% of the EBT, which is $438,200 * 0.35 = $153,370.

The change in earnings after taxes will be the difference between the taxes paid under the conservative plan and the aggressive plan, which is $153,370 - $178,850 = -$25,480.