Question

You run a perpetual encabulator machine, which generates revenues averaging $29 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 15%. Your firm’s long-term borrowing rate is 12%.

Now you are approached by Studebaker Capital Corp., which proposes a fixed-price contract to supply raw materials at $17.4 million per year for 8 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.)

Answer 1