Jason Kidwell is considering whether to acquire a local toy manufacturing company, Toys 'n' Things Inc. The company's annual income statements for three years are as follows:

	2014	2013	2012
Revenues	$2,243,155	$2,001,501	$2,115,002
Cost of goods sold	(1,458,051)	(1,300,976)	(1,374,751)
Gross profits	$785,104	$700,525	$740,251
Depreciation and administrative expenses	(574,316)	(550,150)	(561,500)
Net operating income	$210,798	$150,375	$178,751

a. Jason has learned that small private companies such as this one typically sell for EBITDA multiples of three to four times. Depreciation expense equals $50,000 per year. What value would you recommend Jason put on the company?

b. The current owner of Toys 'n' Things indicated to Jason that he would not take less than five times 2014 EBITDA to sell out. Jason decides that, based on what he knows about the company, the price could not be justified. However, upon further investigation, Jason learns that the owner's wife is paid $100,000 a year for administrative services that Jason thinks could be done by a $50,000-per-year assistant. Moreoever, the owner pays himself a salary of $250,000 per year to run the business. In addition, Jason thinks that, by outsourcing raw materials to Asia, he can reduce the firm's cost of good sold by 10%. After making adjustments for excessive salaries, what value should Jason place on the business? Can Jason justify the value the owner is placing on the business?

Assume that Jason Kidwell is able to purchase Toys 'n' Things Inc. for $2.2 million. Jason estimates that after initiating his changes in the company's operations (i.e., the salary savings plus outsources savings), the firm's cost of goods sold is 55% of firm revenues, and operating expenses are equal to a fixed component of $250,000 plus a variable cost component equal to 10% of revenues.

a. Under these circumstances, estimate the firm's net operating income for revenue levels of $1 million, $2 million, and $4 million. What is the percentage change in operating income if revenues go from $2 million to $4 million? What is the percentage change in operating income if revenues change from $2 million to $1 million?

b. Assume now that Jason is able to modify the firm's cost structure such that the fixed component of operating expenses declines to $50,000 per year but the variable cost rises to 30% of firm revenues. Answer part a, above, under this revised cost structure. Which of the two cost structures generates the highest level of operating leverage? What should be the effect of the change in cost structure on the firm's equity beta?

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