Question

Hicks Health Clubs, Inc., expects to generate an annual EBIT of $502,000 and needs to obtain financing for $1,140,000 of assets. Its tax bracket is 39%. If the firm uses short-term debt, its rate will be 8.0%, and if it uses long-term debt, its rate will be 9.0%. By how much will their earnings after taxes change if they choose the more aggressive financing plan instead of the more conservative plan? (Amounts in parentheses indicate negative value.)

Multiple Choice

• $11,954

• ($11,954)

• ($6,954)

• $6,954

Answer 1

i) Net earnings if conservative plan ie. Short term debt @ 8%

Net earnings = (EBIT - Interest) * (1 - Tax rate)

Here,

EBIT = $5,02,000

Interest = Financing amount * Interest rate

Interest = $11,40,000 * 8% = $91,200

Tax rate = 39% or 0.39

Now,

Net earnings = ($5,02,000 - $91,200) * (1 - 0.39)

Net earnings = $4,10,800 * 0.61

Net earnings = $2,50,588

ii) Net earnings if choose more aggressive plan ie. Long term debt @ 9%

Net earnings = (EBIT - Interest) * (1 - Tax rate)

Here,

EBIT = $5,02,000

Interest = $11,40,000 * 9% = $1,02,600

Tax rate = 39% or 0.39

Now,

Net earnings = ($5,02,000 - $1,02,600) * (1 - 0.39)

Net earnings = $3,99,400 * 0.61

Net earnings = $2,43,634

Net changes in earnings after tax if they choose aggressive plan than conservative plan :

Net changes in earnings = Earnings as per aggressive plan - Earnings as per conservative plan

Net changes in earnings = $2,43,634 - $2,50,588

Net changes in earnings = ($6,954)

Net earning is decreasing if they choose aggressive plan.