Olinde Electronics, Inc., produces stereo components that sell for $100. Olinde’s fixed costs are $200,000; the firm produces and sells 5,000 components each year; EBIT is currently $50,000; and Olinde’s assets (all equity financed) are $500,000. The firm estimates that it can change its production process, adding $400,000 to investment costs and $50,000 to fixed operating costs. This change will reduce variable costs per unit by $10 and increase output by 2,000 units, but the sales price on all units must be lowered to $95 to permit sales of the additional output. Olinde has tax loss carryovers that cause its tax rate to be 0 percent. It uses no debt, and its average cost of funds is 10 percent.
a. Should Olinde make the change?
b. Would Olinde’s degree of operating leverage increase or decrease if it made the change? What about its operating breakeven point?
c. Suppose Olinde could not raise additional equity financing and had to borrow the $400,000 to make the investment at an interest rate of 8 percent. Use the DuPont equation (Chapter) to find the expected ROA of the investment. Should Olinde make the change if it must use debt financing?
d. What would Olinde’s degree of financial leverage be if it borrowed the $400,000 at the 8 percent interest rate?