1. Firm A has $10,000 in assets entirely financed with equity. Firm B also has $10,000 in assets, but these assets are financed by $5,000 in debt (with a 10 percent rate of interest) and $5,000 in equity. Both firms sell 10,000 units of output at $2.50 per unit. The variable costs of production are $1, and fixed production costs are $12,000. (To ease the calculation, assume no income tax.)
a. What is the operating income (EBIT ) for both firms?
b. What are the earnings after interest?
c. If sales increase by 10 percent to 11,000 units, by what percentage will each firm’s earnings after interest increase? To answer the question, determine the earnings after taxes and compute the percentage increase in these earnings from the answers you derived in part b .
d. Why are the percentage changes different?
2. The specialty chemical Company operates a crude oil refinery located in New Iberia, LA. The company refines crude oil and sells the by-products to companies that make plastic bottles and jugs. The firm is currently planning for its refining needs for one year hence. Specifically, the firms analysts estimate that specialty will need to purchase 1 million barrels of crude oil at the end of of the current year to provide the feed stock for its refining needs for the coming year. The 1 million barrels of crude oil will be converted into by products at an average cost of $25 per barrel that Specialty expects to sell for $190 million, or $190 per barrel of crude used. The current spot price of oil is $135 per barrel and Specialty has been offered a forward contract by its investment banker to purchase the needed oil for a delivery price in one year of $140 per barrel.
a. Ignoring taxes, what will Specialty’s profits be if oil prices in one year are as low as $120 or as high as $160, assuming that the firm does not enter into the forward contract?
b. If the firm were to enter into forward contract, demonstrate how this would be effectively lock in the firm’s cost of fuel today, thus hedging the risk of fluctuating crude oil prices on the firm’s profits for the next year.
a. Ignoring taxes, what will specialty’s profits be if oil prices in one year are as low as $120 or as high as $160, assuming that the firm does not enter into forward contract? Round to the nearest dollar.
Price of Oil/ bbl Unhedged Annual Profits
$120 _________
$125 _________
$130 _________
$135 _________
$140 _________
$145 _________
$150 _________
$155 _________
$160 _________
b. If the firm were to enter into forward contract, demonstrate how this would be effectively lock in the firm’s cost of fuel today, thus hedging the risk of fluctuating crude oil prices on the firm’s profits for the next year.
A B C D E F G
Price Total cost of Total Revenues Total Refining Unhedged Profits/loss Hedged Annual
of Oil/ Oil (Ax1m) =$190x1m Costs Annual Forward Profits
bbl =$25x1m Profits Contracts =E+F
=C+B+D =(A-$140)x1m
120 120,000,000 190,000,000 25,000,000 45,000,000
125 125,000,000 190,000,000 25,000,000 40,000,000
130 130,000,000 190,000,000 25,000,000 35,000,000
135 135,000,000 190,000,000 25,000,000 30,000,000
140 140,000,000 190,000,000 25,000,000 25,000,000
145 145,000,000 190,000,000 25,000,000 20,000,000
150 150,000,000 190,000,000 25,000,000 15,000,000
155 155,000,000 190,000,000 25,000,000 10,000,000
160 160,000,000 190,000,000 25,000,000 5,000,000
