Question

You n n a perpetual encabulator machine, which generates evenues averaging $27 million per year. Raw material costs are 60% of revenues. These costs are va able hey are always proportional to revenues. There are no other operating costs. The cost of capital is 12%. Your firms long term borrowing rate is 9% Now you are approached by Studebaker Capital Corp., which proposes a fixed-price contract to supply raw materials at $16.2 million per year for 12 years. a. What happens to the operating leverage and business risk of the encabulator machine if you agree to this fxod-price contract? Operating leverage and business risk increases o operating leverage and business risk decreases b. Calculate the present value of millions. Round your answers to the nearest whole dolar amount.) the encabulator machine with and without the fixed-price contract. (De not round intermediate calculations. Enter your answers in dollars not in Present Value Wth contract Without contract

Answer 1

a. If we accept the fixed price contract, the firm's operating and business risk is going to be increase. Because, irrespective of sales and revenues the amount of $16.2 Million per year has to pay to the supplier for 12 years. When the fixed pay is there for any firm, it leads to operating leverage to the firm.

Hence, option 1 is correct

b.the present value with contract= $16.2*7.1607 (is the annuity factor at 9% for 12 years)

= $116 million

without contract= $27 million * 60%= $16.2 Million

the present value will be same in this both aspects