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 percent, and with a long-term financing plan their rate will be 9 percent. By how much will their earnings after tax change if they choose the more conservative financing plan instead of the more aggressive plan?

Question

Quizplus · Accepted Answer

The conservative plan (long-term) has a higher interest rate, leading to higher interest expenses and thus lower earnings after tax compared to the aggressive plan (short-term). The difference in interest expenses is $18,000, and after accounting for taxes, the change in earnings after tax is -$10,800.