You run a perpetual encabulator machine, which generates revenues averaging $25 million per year. Raw material...

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You run a perpetual encabulator machine, which generatesrevenues averaging $25 million per year. Raw material costs are 60%of revenues. These costs are variable?they are always proportionalto revenues. There are no other operating costs. The cost ofcapital is 11%. Your firm’s long-term borrowing rate is 8%.
Now you are approached by Studebaker Capital Corp., whichproposes a fixed-price contract to supply raw materials at $15million per year for 10 years.
a. What happens to the operating leverage andbusiness risk of the encabulator machine if you agree to thisfixed-price contract?
Operating leverage and business risk increases
Operating leverage and business risk decreases
b. Calculate the present value of theencabulator machine with and without the fixed-price contract.(Do not round intermediate calculations. Enter your answersin dollars not in millions. Round your answers to the nearest wholedollar amount.)
Present Value
With contract $
Without contract $

Answer & Explanation Solved by verified expert

3.5 Ratings (349 Votes)

a If you agree to the fixed price contract operating leverageincreases Changes in revenue result in greater than proportionatechanges in profit See Answer

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You run a perpetual encabulator machine, which generatesrevenues averaging $25 million per year. Raw material costs are 60%of revenues. These costs are variable?they are always proportionalto revenues. There are no other operating costs. The cost ofcapital is 11%. Your firm’s long-term borrowing rate is 8%.Now you are approached by Studebaker Capital Corp., whichproposes a fixed-price contract to supply raw materials at $15million per year for 10 years.a. What happens to the operating leverage andbusiness risk of the encabulator machine if you agree to thisfixed-price contract?Operating leverage and business risk increasesOperating leverage and business risk decreasesb. Calculate the present value of theencabulator machine with and without the fixed-price contract.(Do not round intermediate calculations. Enter your answersin dollars not in millions. Round your answers to the nearest wholedollar amount.)Present ValueWith contract$Without contract$

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