Oleck Inc. produces stereo components that sell at P = $100 per unit. Oleck’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 Oleck’s assets (all equity-financed) are $500,000. Oleck 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. Oleck has tax loss carry-forwards that cause its tax rate to be zero, it uses no debt, and its average cost of capital is 10%. Suppose Oleck was unable to raise additional equity financing and had to borrow the $400,000 at an interest rate of 10% to make the investment. Use the DuPont equation to find the expected ROA of the investment. Calculate incremental ROA. Should Oleck make the change if debt financing must be used? Answers: a) Incremental ROA =
Oleck Inc. produces stereo components that sell at P = $100 per unit. Oleck’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 Oleck’s assets (all equity-financed) are $500,000. Oleck 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. Oleck has tax loss carry-forwards that cause its tax rate to be zero, it uses no debt, and its average cost of capital is 10%.
Suppose Oleck was unable to raise additional equity financing and had to borrow the $400,000 at an interest rate of 10% to make the investment. Use the DuPont equation to find the expected ROA of the investment. Calculate incremental ROA. Should Oleck make the change if debt financing must be used?
Answers:
a) Incremental ROA =
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