Capital Structure Decisions
15-7
a.
Here are the steps involved:
(1)
Determine the variable cost per unit at present, V:
Profit
= P(Q) - FC - V(Q)
$500,000
= ($100,000)(50) - $2,000,000 - V(50)
50(V)
= $2,500,000
V
= $50,000.
(2)
Determine the new profit level if the change is made:
New profit
= P
2
(Q
2
) - FC
2
- V
2
(Q
2
)
= $95,000(70) - $2,500,000 - ($50,000 - $10,000)(70)
= $1,350,000.
(3)
Determine the incremental profit:
Profit = $1,350,000 – $500,000 = $850,000.
(4)
Estimate the approximate rate of return on new investment:
Return = Profit/Investment = $850,000/$4,000,000 = 21.25%.
Since the return exceeds the 15 percent cost of equity, this analysis suggests that the
firm should go ahead with the change.
b.
The change would increase the breakeven point:
Old:
Q
BE
=
=
= 40 units.
New:
Q
BE
=
= 45.45 units.
c.
It is impossible to state unequivocally whether the new situation would have more or
less business risk than the old one.
We would need information on both the sales
probability distribution and the uncertainty about variable input cost in order to make
this determination.
However, since a higher breakeven point, other things held
constant, is more risky.
Also the percentage of fixed costs increases:
Old:
=
= 44.44%.
New:
=
= 47.17%.
Chapter 15