A firm needs $1 million in additional funds. These can be borrowed from a commercial bank with a loan at 6 percent for one year or from an insurance company at 9 percent for five years. The tax rate is 30 percent.

a. What will be the firm’s earnings under each alternative if earnings before interest and taxes (EBIT) are $430,000?

b. If EBIT will remain $430,000 next year, what will be the firm’s earnings under each alternative if short-term interest rates are 4 percent? If short-term interest rates are 14 percent?

c. Why do earnings tend to fluctuate more with the use of short-term debt than with long-term debt? If long-term debt had a variable interest rate that fluctuated with changes in interest rates, would the use of short-term debt still be riskier than long-term debt?