Merville Corporation will begin operations next year to produce a single product at a price of $12 per unit. Merville has a choice of two methods of production: Method A, with variable costs of $6.75 per unit and fixed operating costs of $675,000, and Method B, with variable costs of $8.25 per unit and fixed operating costs of $401,250. To support operations under either production method, the firm requires $2,250,000 in assets, and it has established a debt-to-total-assets ratio of 40 percent. The cost of debt is rd = 10 percent. The tax rate is irrelevant for the problem, and fixed operating costs do not include interest.
a. The sales forecast for the coming year is 200,000 units. Under which method would EBIT be more adversely affected if sales did not reach the expected levels? (Hint: Compare DOLs under the two production methods.)
b. Given the firm’s current debt, which method would produce the greater percentage increase in earnings per share for a given increase in EBIT?

c. Calculate DTL under each method, and then evaluate the firm’s total risk under each method.

d. Is there some debt ratio under Method A that would produce the same DTLA as the DTLB that you calculated in part c?