case3_05_2

case3_05_2 - Case 3 Optimal Operating and Financial...

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Case 3 Optimal Operating and Financial Leverage Fit Trainer Company Universiteit Maastricht Faculty of Economics and Business Administration Financial Management and Policy 3020B Tutor: J.Budek Tutorial Group: 2 Dehnadi, Zahir I252786 Sprengers, Rutger I232785 1
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te: The after tax cost of debt in Figure 3in the case seem to be calculated wrongly. We corrected this mistake by multiplying the values given by 0.6 to account for tax effects. 1. Discuss the external business risk factors with which Fit Trainer Company must contend. If a company is entirely financed by equity, it would be susceptible to business risk or changes in the overall economic climate. In the Fit trainer case there are 5 factors that have to be taken under consideration. First, the demand instability and the inherent cyclical nature of the exercise industry do pose considerable business risk for the company. Moreover the tax rate and the labour costs constitute risk factors since the direction of the percentage changes are unknown (+/- 25 percentage points for taxes and +/- 5-20 percent for labour costs). Further the final sales price of the company’s shares, which is subject to the interest of investors, will determine the total amount of equity of the company. Lastly, operating leverage, which is a measurement of the degree to which a firm or project relies on fixed rather than variable costs, can be pinpointed as a business risk factor. This factor is especially significant for plan B as this plan has higher fixed costs than plan A. 2. Discuss the principles of operating leverage as they relate to production plans A and B. Operating leverage can be defined as a measurement of the degree to which a firm or project relies on fixed rather than variable costs. Brigham and Davis state that “a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in EBIT”. We van derive from this that the higher the degree of operating leverage, the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. If the majority of costs for a company or project are fixed, then the costs will remain high while sales are dropping. Applying this to the case at hand, it is obvious that plan A has a lower operating leverage with fixed costs of $3.6 million and variable costs of $1, 150 per unit. On the other hand, plan B has higher operating leverage with fixed costs of $4.4 million and variable costs of 1,110 per unit. The expectations of future sales determine the plan to be chosen. In the Case of low sales, the company should take plan A with lower operating leverage as the decline in EBIT will be less than for plan B. In the high sales case, Fit trainer Company should go for higher operating leverage as EBIT will increase more than with low operating leverage. 2
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case3_05_2 - Case 3 Optimal Operating and Financial...

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