case3_05

case3_05 - 1. Business risk is the risk a firms common...

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1. Business risk is the risk a firm’s common stockholders would face if the firm has no debt. While analyzing Fit Trainer Company, 5 external business risk factors should be taken into account. The first significant external business risk is the demand instability, as well as the cyclical nature of the exercise industry. The foreseen variability in costs for labor and taxes should also be included as a risk factor, since for the taxes the direction and amount of change is still unknown and labor costs could increase by as little as 5 to as much as 20%. The final sales price of the shares will determine the total amount of equity. However, this price is subject to the interest of the investors, which is again uncertain. The last business risk that should be incorporated is the operating leverage, which is determined by the extend to which the costs are fixed. Of course, this is a greater risk for Plan B, because the fixed costs are higher compared to Plan A. 2. As stated in the book, a high degree of operating leverage, other factors held constant implies that a relatively small change in sales result in a large change in EBIT. In this case, Fit Trainer Company can choose between two plans. Plan A has fixed costs of $3.6 million and variable costs of $1150 per unit. Plan B will have fixed costs of $4.4 million and variable costs of $1110. Therefore, Plan B will have a higher operating leverage. It will depend on the company’s forecast of amount of sales, whether they will choose Plan A or B. In case of high sales the higher operating will be beneficial and hence Plan B will generate more profit. In case of low expected sales, the company should choose Plan A, which has a lower operating leverage and consequently a lower risk in case of low sales. 3. As can be seen on the tables on the next page Plan A has a smaller expected EBIT than plan B ($ 3,612,500 to $ 3,966,500 ). However Plan A has a higher return on investment due to the lower start-up costs. In addition Plan A is less risky than Plan B which can be
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case3_05 - 1. Business risk is the risk a firms common...

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