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 aggressive financing plan instead of the more conservative plan?

Question

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The more aggressive financing plan will result in higher interest expenses, which will reduce the earnings before taxes. The reduction in earnings before taxes will then lead to a reduction in earnings after taxes. The amount of the reduction in earnings after taxes can be calculated as follows:Interest expense = $1,200,000 x 9% = $108,000Earnings before taxes = $750,000 - $108,000 = $642,000Earnings after taxes = $642,000 x (1 - 40%) = $385,200The reduction in earnings after taxes is $750,000 - $385,200 = $10,800.