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14 Chapter model

# 14 Chapter model - 14 Chapter model 7:10 Chapter 14 Capital...

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14 Chapter model 3/22/2010 7:10 Chapter 14. Capital Structure and Leverage Input Data Plan A Plan B Low FC High FC Price \$2.00 \$2.00 Variable costs \$1.50 \$1.00 Fixed costs \$20,000 \$60,000 Total assets \$200,000 \$200,000 Tax Rate 40% 40% A's breakeven units = 40,000. Operating Performance Plan A: Low Fixed, High Varia Data Applicable to Both Plans Units Dollar Operating Demand Probability Sold Sales Costs EBIT NOPAT Terrible 0.05 0 \$0 \$20,000 (\$20,000) (\$12,000) Poor 0.2 40,000 \$80,000 \$80,000 \$0 \$0 Average 0.5 100,000 \$200,000 \$170,000 \$30,000 \$18,000 Good 0.2 160,000 \$320,000 \$260,000 \$60,000 \$36,000 Wonderful 0.05 200,000 \$400,000 \$320,000 \$80,000 \$48,000 Expected Values: 100,000 \$200,000 \$170,000 \$30,000 \$18,000 Standard Deviation (SD): 49,396 \$98,793 \$24,698 Coefficient of Variation (CV): 0.49 0.49 0.82 The results generated above are graphed here: In this chapter, we introduce two new dimensions of risk, business risk and financial risk. B is the risk inherent in the firm's operations, and it would be there even if the firm used no deb risk is the additional risk borne by the stockholders as a result of the use of debt. BUSINESS RISK AND OPERATING LEVERAGE (Section 14.2) Operating leverage reflects the degree to which fixed costs are embedded in a firm's operatio a high percentage of a firm's costs are fixed, then the firm is said to have high operating leve these costs are incurred even if sales decline. High operating leverage produces a situation small change in sales can result in a large change in operating income. The following examp two operational plans with different degrees of operating leverage. Using the input data give examine the firm's profitability under two operating plans, in different states of the economy are given). Which plan is better? Based on expected profits and ROE, Plan B looks better. However, Pl riskier, as measured by the standard deviation (SD) and the coefficient of variation (CV). So, tradeoff between risk and return--B is more profitable, but A is less risky. Someone will have between the two plans, but at this point we have no basis for making the choice. Note also that Plan A will break even at sales as low as 40,000 units, while Plan B would have loss at that level. B's breakeven point is 50% higher, at 60,000 units.

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Plan A FC / (P VC) \$20,000 / \$2.00 \$1.50 40,000 Units. Plan B FC / (P VC) \$60,000 / \$2.00 \$1.00 60,000 Units. (1) B has a much higher breakeven point, and (2) B has more operating leverage in the sense change in sales leads to a larger change in profits than for A. We can see from the table that A's breakeven point is at 40,000 units. We can see from the ta from the graph that B's breakeven point is between 40,000 and 100,000 units, but we cannot point. However, we can use the following formula to find the exact breakeven point: Q BE = FC / (P − VC) Q BE = Q BE = Q BE = BE B = BE B = BE B = 0 20,000 40,000 60,000 80,000 100,000 120,000 \$0 \$50,000 \$100,000 \$150,000 \$200,000 Plan B: High Fixed Costs, High Operating Leverage Sales (units) Revenues and Costs 0 20,000 40,000 60,000 80,000 100,000 120,000 \$0 \$50,000 \$100,000 \$150,000 \$200,000 Plan A: Low Fixed Costs, Low Operating Leverage Sales (units) Revenues and Costs
Debt Cost Schedule Amount Cost of D/A ratio borrowed debt 0% \$0 8.0% 10% \$20,000 8.0% 20% \$40,000 8.3% 30% \$60,000 9.0% 40% \$80,000 10.0% 50% \$100,000 12.0% 60% \$120,000 15.0% OPTION 1: Finance Plan B entirely with common equity

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14 Chapter model - 14 Chapter model 7:10 Chapter 14 Capital...

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