case3_04_2 - Case 3 Optimal Operating and Financial...

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Case 3 Optimal Operating and Financial Leverage Maastricht University Faculty of Economics and Business Administration Maastricht, November 23 2004 Arends, Tangela I199524 Middelbeek, Robbert I168165 Pollaert, Rian I161446 Group 2 Subgroup 2 Tutor: Nils Kok Financial Management & Policy Report Case 3
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Introduction Fit Trainer Company is a starting company that wants to build exercise equipment. With the available manufacturing plant Fit Trainer company can choose between two Plans. Plan A being more labor intensive and Plan B having a more comprehensive finishing process. An analysis about the plans is made and based on it, recommendations are made. Furthermore, the capital structure of the company has to be determined. After analyzing the effects of different levels of debt an optimal capital structure is suggested. Business risk is defined as the risk a common stockholder would face if the firm had no debt. In the case of Fit Trainer Company the factors affecting the business risk are the following. The demand variability, as this is cyclical three scenarios have been developed, namely: most likely, optimistic and pessimistic. The input cost variability, the variable cost could increase with an amount between 5 up to 10%. Furthermore, also the taxes will change in either direction by a maximum of 25 percentage points. Lastly, the operating leverage is a very important factor that affects the business risk and is being discussed in the next section. Operating leverage is the share of fixed costs in the total production costs of a product. The larger the fixed costs, the higher the operating leverage. Having a high operating leverage implies that a relatively small change in sales results in a high change in EBIT. In our case, the sales price of the product is $1400, and the variable production costs are $1150 and $1110 respectively under plan A and plan B. This implies that the difference between sales price and variable costs (1400-1150 =250, and 1400-1110=290) must cover the fixed costs. For every product sold, $250 and $290 respectively can be “used” to cover fixed costs. So if the fixed costs are $3.600.000 under plan A and $4.400.000 under plan B, we need to sell 14400 products for plan A and 15173 products for plan B to cover the fixed costs. These quantities are called the breakeven quantities. When exactly this number of products is sold, the EBIT will be 0. (3.600.000/250= 14400 and 4.400.000/290=15172,4) The 2 graphs displayed below show the sales revenue and operating costs for the different sales quantities. The intersection point of the 2 lines is the break-even point, where the sales revenue equals the operating costs. (So EBIT=0). 2
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The Tables show the sales revenues and variable costs for the different sales quantities, using the scenarios described in the case –being pessimistic, most likely and optimistic-. Using these data, the Earnings Before Interest and Taxes (EBIT) can be calculated for each scenario, and can be merged together into the expected EBIT
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