You run a perpetual encabulator machine, which generates revenues averaging $20 million per year. Raw material costs are 50% of revenues. These costs are variable-they are always proportional to revenues. There are no other operating costs. The cost of capital is 9%. Your firm's long-term borrowing rate is 6%.
Now you are approached by Studebaker Capital Corp., which proposes a fixed-price contract to supply raw materials at $10 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?
b. Calculate the present value of the encabulator machine with and without the fixed- price contract.
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