Question

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 aggressive financing plan instead of the more conservative? A. $10,800 B. ($10,000) C. ($6,000) D. $6,000?

Answer 1

Answer:

A. $10,800

Explanation:

The more aggressive financing plan will be taking a short-term debt and hope to generate enought to pay the principal.

The difference in rate is of 1.50%

short-term interest: 1,200,000 x 7.50% =   90,000

long-term interest:  1,200,000 x 9.00% = 108,000

Net Income using short-term financing:

(750,000 - 90,000) x ( 1 - 40%) = 396,000

(750,000 - 108,000) x ( 1 - 40%) = 385,200

Difference: 396,000 - 385,200 = 10,800

TYhe net income taking a short-term debt is 10,800 dollars greater.