Hicks Health Clubs, Inc., expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. Their tax bracket is 40%. If the firm goes with a short-term financing plan, their rate will be 7.5%, and with a long-term financing plan their rate will be 9%. By how much will their earnings after taxes change if they choose the more conservative financing plan instead of the more aggressive plan?

Question

Quizplus · Accepted Answer

1) Calculate the interest expense for short-term financing: 
Interest expense = $1,200,000 x 7.5% = $90,000

2) Calculate the interest expense for long-term financing: 
Interest expense = $1,200,000 x 9% = $108,000

3) Calculate earnings before taxes (EBT) for each financing plan: 
EBT (short-term) = $750,000 - $90,000 = $660,000 
EBT (long-term) = $750,000 - $108,000 = $642,000

4) Calculate earnings after taxes (EAT) for each financing plan: 
EAT (short-term) = $660,000 x (1 - 0.40) = $396,000 
EAT (long-term) = $642,000 x (1 - 0.40) = $385,200

5) Calculate the difference in earnings after taxes: 
$396,000 - $385,200 = $10,800

Therefore, the more conservative financing plan (long-term) would result in a decrease in earnings after taxes by $10,800.