Schweser Satellites, Inc. produces satellite earth stations

Schweser Satellites, Inc produces satellite earth stations that sell for $100,000 each. The firm's fixed costs, F, are $2 million; 50 earth stations are produced and sold each year; profits total $500,000; and the firm's assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $4 million to investment and $500,000 to fixed operating costs. The change will (1) reduce variable costs per unit by $10,000 and (2) increase output by 20 units, but (3) the sales price on all units will have to be lowered to $95,000 to permit sales of the additional output. The firm has tax loss carry-forwards that cause its tax-rate to be zero, its cost of equity is 15%, and it uses no debt.

a) Should the firm make the change?
b) Would the firms operating leverage increase or decrease if it made the change? What about break-even point?
c) Would the new situation expose the firm to more or less business risk that the old one?

Here are the estimated ROE distributions for Firms A,B,and C:

(see attached file for data)

a) Calculate the expected value and standard deviation for Firm C's ROE.
ROE(a) = 10.0%, Standard deviation (a) = 5.5%. ROE (b) = 12.0 %, Standard deviation(b) = 7.7%

b) Discuss the relative riskiness of the three firms' returns. (Assume that these distributions are expected to remain constant over time.)
c) Now suppose all three firms have the same standard deviation of basic earning power (EBIT/Total assets), standard deviation is 5.5%. What can we tell about the financial risk of each firm?