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    Operating leverage,equity beta & cost structures

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    Assume that Jason Kidwell is able to purchase Toy's Things, Inc., for $2.2 million. Jason estimates that after initiating his changes in the company's operations, the firm's cost of goods are 55% of firm revenues and operating expenses are equal to a fixed component of $250,000 plus a variable cost component equal to 10% of revenues.

    a. Under the above circumstances, estimate the firm's net operating income for revenue levels of $1 million, $2 million, and $4 million. What is the percent change in operating income if revenues go from $2 million to $4 million? What is the percent change in operating income if revenues change from $2 million to $1 million?

    b. Assume now that Jason is able to modify the firm's cost structure such that the fixed component of operating expenses declines to $50,000 per year, but the variable cost rises to 30% of firm revenues. Answer Part a above under this revised cost structure. Which of the two cost structures generates the highest level of operating leverage? What should be the effect of the change in cost structure on the firm's equity beta?

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    Solution Summary

    The solution contains the computation of operating leverage and return for different levels of cost structures and also the effect of cost structures on the equity beta of the firm.