If higher debt forces the company’s managers to be more careful with shareholders’ money, what specific situations can you provide as example/s of events that can push a company with higher debt to have bankruptcy-related problems?
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Discussion Questions:
1. If higher debt forces the company’s managers to be more careful with shareholders’ money, what specific situations can you provide as example/s of events that can push a company with higher debt to have bankruptcy-related problems?
2. RAEB Electronics produces stereo components that sell at P = $100 per unit. RAEB’s fixed costs are $200,000, variable costs are $50 per unit, 5,000 components are produced and sold each year, EBIT is currently $50,000, and RAEB’s assets (all equity-financed) are $500,000.
RAEB can change its production process by adding $400,000 to assets and $50,000 to fixed operating costs. This change would (1) reduce variable costs per unit by $10 and (2) increase output by 2,000 units, but (3) the sales price on all units would have to be lowered to $95 to permit sales of the additional output. RAEB has zero tax rate, it uses no debt, and its average cost of capital is 10%.
a. How much will be RAEB’s new EBIT under the proposed new production process?
What is the incremental EBIT (i.e. old EBIT vs. new EBIT)?
b. Using return on assets (ROA) analysis on the incremental amounts brought by the new production process, should RAEB make the change? Why or why not?
c. How much would RAEB’s break-even point increase or decrease if it made the change?
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