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case3_05_3 - Case 3 Optimal Operating and Financial...

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Unformatted text preview: Case 3 Optimal Operating and Financial Leverage Fit Trainer Company University Maastricht Faculty of Economics and Business Administration Maastricht, 22-11-2005 Barneveld Binkhuysen, C., I224758 Boberg, N., I226440 Llona Gutierrez, J., I363162 Losen, J., I245240 International Business Course: Financial Management and Policy Code: 3020B Group 4 Tutor: Pavlov, B. Question 1 Business risk is the risk a firms 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 extent 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. Question 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 companys 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. Question 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 derived from the lower variation coefficient. (0.8563 to 0.9046). Since Fit Trainer Company is facing business risk, Plan A with its higher ROI and lower risk might be the best choice for the company. 2 Break-even points Break-even points are calculated with the following formula: V P F Q BE- = The break-even points are 14,400 and 17,600 unit for Plan A and B, respectively which indicates that Plan B is riskier, since more units have to be sold before the break-even point will be reached....
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case3_05_3 - Case 3 Optimal Operating and Financial...

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