Problem 1. Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firm's fixed costs, F, are $2 million; 50 earth stations are produced and sold each year; profits total $500,000; and the firm's assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $4 million to investment and $500,000 to fixed operating costs. This charge will (1) reduce variable costs per unit by $10,000 and (2) increase output by 20 units, but (3) the sales price on all units will have to be lowered to $95,000 to permit sales of the additional output. The firm has tax loss carry-forwards that cause its tax rate to be zero, its cost of equity is 15 percent, and it uses no debt.
a. Should the firm make the change? Explain
b. Would the firm's operating leverage increase or decrease if it made the changes? What about the breakeven point? Explain
c. Would the new situation expose the firm to more or less business risk than the old one? Explain
Problem 2. You have been hired as a financial consultant by two firms, Alpha Industries (Firm A) and Zed Corporation (Firm Z). Firm A is in the fast-growing microcomputer retail sales industry, while Firm Z manufactures office equipment such as pencil sharpeners, staplers, and tape dispensers. Your task is to recommend optimal capital structure for the two firms. Discuss the factors that would influence your decision, and specifically how each of these factors apply to each firm. Here are some additional points about the two firms:
(1) Firm A generally leases its stores, while Firm Z purchases its plants.
(2) Firm A's stock is widely held, while the family of Firm Z's founder holds 40 percent of its stock.
(3) Firm Z has a significant amount of accelerated depreciation expense each year, while Firm A has almost none.
(4) Firm A has demonstrated high growth and profitability over the last five years. On the other hand, Firm Z's growth averaged a modest 5 percent per year, and its profit margins and ROE's have been unspectacular.