Firm A Has $10,000 In Assets Financed With Equity

Firm A Has 10 000 in assets entirely financed with equity Firm B

Firm A Has $10,000 in assets entirely financed with equity Firm B

Analyze the financial scenarios for two firms with different capital structures, sales projections, and associated risks at varying oil prices. Calculate operating income, earnings after interest, and assess the impact of sales increases and hedging strategies on profits, considering the nuances of leverage and price fluctuations.

Paper For Above instruction

The financial dynamics of firms operating under different capital structures reveal profound insights into their risk profiles and profitability. The contrast between Firm A, which finances its assets solely with equity, and Firm B, which employs leverage through debt, provides a clear perspective on how capital structure influences operating income, earnings, and sensitivity to sales volume changes and commodity price fluctuations.

Part 1: Analysis of Operating Income and Earnings After Interest for Firms A and B

Firm A, with assets totaling $10,000 financed exclusively by equity, generates revenue from selling 10,000 units at $2.50 per unit, resulting in gross revenue of $25,000. The variable costs associated with production amount to $1 per unit ($10,000), and fixed costs are $12,000. The operating income or Earnings Before Interest and Taxes (EBIT) is calculated as follows:

EBIT = Total Revenue - Variable Costs - Fixed Costs

= ($25,000) - ($10,000) - ($12,000) = $3,000

This indicates that Firm A has an operating income of $3,000. Since there is no debt, and thus no interest expense, the earnings after interest are equal to EBIT, amounting to $3,000.

Firm B operates with the same total assets of $10,000 but has financed $5,000 with debt at a 10% interest rate and $5,000 with equity. The interest expense for Firm B is 10% of $5,000, which equals $500. Using the same sales volume and cost structure, the gross revenue remains at $25,000, and the variable costs are the same at $10,000, with fixed costs held at $12,000:

EBIT = $25,000 - $10,000 - $12,000 = $3,000

However, after deducting interest expense, the earnings before taxes (EBT) are:

EBT = EBIT - Interest = $3,000 - $500 = $2,500

Assuming no income taxes, the earnings after interest equate to $2,500.

Part 2: Impact of a 10% Increase in Sales Volume to 11,000 Units

Projected new sales volume is 11,000 units at $2.50 per unit, totaling $27,500 in revenue. Variable costs increase proportionally to output: $1 per unit results in $11,000. Fixed costs remain at $12,000. First, calculate the new EBIT:

EBIT = $27,500 - $11,000 - $12,000 = $4,500

For Firm A, the earnings after interest are identical to EBIT due to no debt: $4,500. For Firm B, subtract the interest expense of $500:

EBT = $4,500 - $500 = $4,000

Consequently, the earnings after interest for Firm B increase from $2,500 to $4,000. The percentage increase in earnings after interest for both firms is calculated relative to their initial earnings:

Firm A: \(\frac{4,500 - 3,000}{3,000} \times 100\% = 50\%\)

Firm B: \(\frac{4,000 - 2,500}{2,500} \times 100\% = 60\%\)

Part 3: Examination of Different Percentage Changes

The differing percentage increases stem from employments of leverage by Firm B. Because fixed costs like interest expenses create a magnifying effect on profit changes, leverage enhances the sensitivity of earnings to sales volume variations. Firm B’s debt amplifies both gains and losses, leading to a higher percentage increase in profits when sales rise, but also increased risk during downturns.

Part 4: Analysis of Specialty Chemical Company's Oil Price Fluctuations and Hedging Strategies

The specialty chemical company’s future oil procurement plan involves purchasing 1 million barrels at an estimated average cost of $25 per barrel, with anticipated sale revenues of $190 million at an effective price of $190 per barrel. Current spot prices are $135 per barrel, but a forward contract is offered to buy at $140 per barrel. The analysis involves determining profits if oil prices fluctuate between $120 and $160 per barrel, both without and with hedging through forward contracts.

Unhedged Scenario:

Profit calculation for different oil prices involves total cost, total revenue, and their differences:

Profit = (Sale Price per Barrel × Quantity) - (Cost per Barrel × Quantity)

Since sale revenue is expected to be $190 million regardless of the purchase price, profits are influenced directly by the actual purchase cost, which varies with oil prices:

- For oil at $120, cost per barrel = $25 (average) + (difference in price) is not directly influencing the purchase, but in this simplified analysis, the profit is primarily impacted by the market price of oil as it affects the value of inventory and margins. Given the question structure, unhedged profits are primarily based on prices relative to the fixed sale revenue, so the profit calculation simplifies to: Profit = Total revenue - Total cost, where total revenue is fixed at $190 million, and total cost varies according to actual oil prices and procurement costs.

- At $120 per barrel, the potential profit is lower due to the lower market price, whereas at $160, the profit is higher. Precise profit values are computed considering the price difference from the baseline, but the general trend is that profits decrease as oil prices fall below the fixed sale price and increase when prices rise above it.

Hedging Strategy:

By entering into a forward contract at $140 per barrel, the company effectively locks in its purchase cost, protecting against price fluctuations. For this example, total cost becomes fixed at $140 million regardless of actual market prices, allowing predictable profit margins:

- If market prices are below $140, the company benefits from the hedge, avoiding higher costs.

- If prices rise above $140, the hedge caps costs, preventing profit erosion.

This hedging mechanism stabilizes profits, reducing risk and providing financial certainty for planning. The actual profit under the hedge is calculated as:

Profit = Total Revenue - (Forward Contract Price × Quantity) = $190 million - $140 million = $50 million.

Thus, the hedge ensures the company’s profitability remains steady at this level, regardless of whether actual market prices are lower or higher.

Conclusion:

The comparative analysis underscores how leveraged firms like Firm B experience magnified profit responses to sales changes, accentuating both gains and risks. Meanwhile, hedging strategies like forward contracts provide a crucial risk mitigation tool in volatile commodity markets, aligning future costs with strategic planning. Both scenarios highlight the importance of capital structure choices and risk management in financial planning and decision-making.

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