Hicks Health Clubs, Inc., expects to generate an annual EBIT of $520,000 and nee

Question

Hicks Health Clubs, Inc., expects to generate an annual EBIT of $520,000 and needs to obtain financing for $1,160,000 of assets. Their tax bracket is 38%. 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 8.5 percent. By how much will their earnings after tax change if they choose the more aggressive financing plan instead of the more conservative? (Amounts in parentheses indicate negative value.) O $7192 O $11,192 O ($1192) O ($7192)

Explanation / Answer

Answer:

Earning after Tax, if Firm goes for Short-Term Financing:
Earning after Tax = EBT – Taxes
EBT = EBIT – Interest
EBT = $520,000 – ($1,160,000 * 7.5%)
EBT = $520,000 - $87,000
EBT = $433,000

Earning after Tax = $433,000 – ($433,000 * 38%)
Earning after Tax = $433,000 - $164,540
Earning after Tax = $268,460

Earning after Tax, if Firm goes for Long-Term Financing:
Earning after Tax = EBT – Taxes
EBT = EBIT – Interest
EBT = $520,000 – ($1,160,000 * 8.5%)
EBT = $520,000 - $98,600
EBT = $421,400

Earning after Tax = $421,400 – ($421,400 * 38%)
Earning after Tax = $421,400 - $160,132
Earning after Tax = $261,268

Aggressive Financing Plan is Short Term Financing at 7.5%, whereas Conservative Financing Plan is Long Term Financing at 8.5%

Change in EAT = $268,460 - $261,268
Change in EAT = $7,192

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