Assignment 5

Financial Management II
Dr. Samra Chaudary

Q1. The Omega Company sells watches for $26, fixed costs are $155,000, and variable costs are $13 per
watch.
a. What is the firm’s gain or loss at sales of 8,000 watches? At 15,000 watches?
b. What is the break-even point? Illustrate by means of a chart.
c. What would happen to the break-even point if the selling price was raised to $37? What
is the significance of this analysis?
d. What would happen to the break-even point if the selling price was raised to $37 but
variable costs rose to $28 a unit?

Q2. Warren Watch is trying to establish its optimal capital structure. Its current capital structure
consists of 30% debt and 70% equity; however, the CEO believes that the firm should use more
debt. The risk-free rate, rRF, is 5%; the market risk premium, RPM, is 5%; and the firm’s tax rate
is 40%. Currently, SSC’s cost of equity is 12.5%, which is determined by the CAPM. What
would be SSC’s estimated cost of equity if it changed its capital structure to 35% debt and 65%
equity?

Q3. Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA
currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2
million shares outstanding. BEA is a zero-growth· firm and pays out all of its earnings as
dividends. The firm's EBIT is $14.933 million, and it faces a 40% federal-plus-state tax rate. The
market risk premium is 4%, and the risk-free rate is 6%. BEA is considering increasing its debt
level to a capital structure with 40% debt, based on market values, and repurchasing shares with
the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt,
and the rate on the new debt will be 9%. BEA has a beta of 1.0.
a. What is BEA's unlevered beta? Use market value D/S (which is the same as w d /ws)
when unlevering.
b. What are BEA's new beta and cost of equity if it has 40% debt?
c. What are BEA's W ACC and total value of the firm with 40% debt?