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FM12 Ch 16 Tool Kit

# FM12 Ch 16 Tool Kit - A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15...

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1/31/2007 Chapter 16. Tool Kit for Capital Structure Decisions: The Basics BUSINESS RISK AND FINANCIAL RISK (Section 16.2) 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 Capital \$200,000 \$200,000 Tax Rate 40% 40% Operating Performance Data Applicable to Both Plans Units Dollar Demand Probability Sold Sales Terrible 0.05 0 \$0 Poor 0.2 40,000 \$80,000 Average 0.5 100,000 \$200,000 Good 0.2 160,000 \$320,000 Wonderful 0.05 200,000 \$400,000 Expected Values: 100,000 \$200,000 Standard Deviation (SD): \$49,396 \$98,793 Coefficient of Variation (CV): 0.49 0.49 A's breakeven units = 40,000. See table. B's breakeven units = 60,000. See calculation below. Plan A: Low Fixed, High Variable Costs Plan B: High Fixed, Low Variable Costs Pre-tax Net Op Profit Return on Pre-tax Net Op Profit Return on Units Operating Operating After Taxes Invested Operating Operating After Taxes Invested Sold Costs Profit (EBIT) (NOPAT) Capital Costs Profit (EBIT) (NOPAT) Capital 0 \$20,000 (\$20,000) (\$12,000) -6.0% \$60,000 (\$60,000) (\$36,000) -18.0% 40,000 \$80,000 \$0 \$0 0.0% \$100,000 (\$20,000) (\$12,000) -6.0% 100,000 \$170,000 \$30,000 \$18,000 9.0% \$160,000 \$40,000 \$24,000 12.0% 160,000 \$260,000 \$60,000 \$36,000 18.0% \$220,000 \$100,000 \$60,000 30.0% 200,000 \$320,000 \$80,000 \$48,000 24.0% \$260,000 \$140,000 \$84,000 42.0% Exp. Values: \$170,000 \$30,000 \$18,000 9.0% \$160,000 \$40,000 \$24,000 12.0% Std. Dev.: \$24,698 7.4% \$49,396 14.8% Coef. of Var.: 0.82 0.82 1.23 1.23 In Chapter 6, we introduced the idea that risk has two principal components, market risk and stand-alone risk. Market risk is measured by beta, while stand-alone risk consists of both market risk plus an element of risk that can be eliminated through diversification. In this chapter, we introduce two new dimensions of risk, business risk and financial risk. Business risk is the risk inherent in the firm's operations, and it would be there even if used no debt. Financial risk is the additional risk borne by the stockholders as a result of the use of debt. Operating Leverage reflects amount of fixed costs embedded in a firm's operations. Thus, if a high percentage of a firm's costs are fixed, hence continue even if sales decline, then the firm is said to have high operating leverage. High operating leverage produces a situation where a small change in sales can result in a large change in operating income. The following example compares two operational plans with different degrees of operating leverage. Using the input data given below, we examine the firm's profitability under two operating plans, in different states of the economy. The probabilities of the economic states are also given in the example. Product sells at same price regardless of how it is produ

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FM12 Ch 16 Tool Kit - A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15...

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