Operating Leverage and Breakeven
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14-1 Operating Leverage and Breakeven
Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firm's fixed costs, F are $2million; 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 investments and $500,000 to fixed operating costs. This 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 $95,000 to permit sales of the additional output. The firm has tax loss carry-forwards that cause its tax rate to be zero, its cost of equity is 15 percent and it uses no debt.
a. Should the firm make the change?
b. Would the firm's operating leverage increase or decrease if it made the change? What about its breakeven point?
c. Would the new situation expose the firm to more or less business risk than the old
d. one?
Answer
a ROI = 21.25%>WACC=15%
B (1) OLold=44.44%; OLnew=47.17%
(2) Qbeold=40; Qbenew=45.45
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Solution Summary
The solution explains the impact on operating leverage and breakeven of a change in costs.
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a. Should the firm make the change?
We should compare the company's profit before and after the change.
Before the change, the total revenue is TR=P*Y=100,000*50=5,000,000
Variable cost (VC) = TR-Profit-F=5,000,000-500,000-2,000,000=2,500,000$
Average Variable cost is then AVC=VC/y=2500,000/50=50,000
After the change, the total revenue will be TR'=P' * Y' =95000*(50+20)= $6,650,000
The fixed costs will be F'= 2000000+500000=2,500,000
Average variable cost is reduced ...
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