Question

You run a perpetual encabulator machine, which generates revenues averaging $25 million per year. Raw material costs are 60% of revenues. These costs are variable−they are always proportional to revenues. There are no other operating costs. The cost of capital is 11%. Your firm’s long-term borrowing rate is 8%.

Now you are approached by Studebaker Capital Corp., which proposes a fixed-price contract to supply raw materials at $15 million per year for 10 years.

a. What happens to the operating leverage and business risk of the encabulator machine if you agree to this fixed-price contract?

	Operating leverage and business risk increases
	Operating leverage and business risk decreases

b. Calculate the present value of the encabulator machine with and without the fixed-price contract. (Do not round intermediate calculations. Enter your answers in dollars not in millions. Round your answers to the nearest whole dollar amount.)

	Present Value
With contract	$
Without contract	$

Answer 1

a). If you agree to the fixed price contract, operating leverage increases. Changes in revenue result in greater than proportionate changes in profit. If all costs are variable, then changes in revenue result in proportionate changes in profit. Business risk, measured by $\beta$assets, also increases as a result of the fixed price contract. If fixed costs equal zero, then: $\beta$assets= $\beta$revenue. However, as PV(fixed cost) increases, $\beta$assets increases.

b). With the fixed price contract:

PV(assets) = PV(revenue) – PV(fixed cost) – PV(variable cost)

= [$25 million / 0.11] - [($15 million / 0.08) x {1 - (1.08^-10}] - [(0.60 x $25 million) / {0.11 x 1.11¹⁰}]

= $227,272,727.3 - $100,651,221 - $48,025,156.2 = $78,593,350

Without the fixed price contract:

PV(assets) = PV(revenue) – PV(variable cost)

= [$25 million / 0.11] – [(0.60 × $25,000,000) / 0.11]

= $227,272,727.3 - $136,363,636.4 = $90,909,091