Could someone explain this solution? I don’t understand the relationship between operating leverage (as in fixed costs?) and Mkt Val and Cost of Equity.
Puca Wrote: ------------------------------------------------------- > Could someone explain this solution? I don’t > understand the relationship between operating > leverage (as in fixed costs?) and Mkt Val and Cost > of Equity. Anyone?
Didn’t do the reading from the CFAI textbooks yet but covered those topics in my undergrad - currently out of my country and don’t have that book with me but give it a try and email me the question and I will see if I can help (omaradnan2 at gmail dot com)
In general, higher operating / financial leverage increases risk due to the higher fixed costs (operational / financial). Earnings volatility is greater with high fixed costs (leverage). To illustrate with a simplified example assuming no variable costs, if revenue = 100 and fixed costs are 80, profit = 20. If revenue = 110, fixed costs are still 80, and profit = 30. Here profit increases 50% even though revenue is up only 10%. Higher risk implies higher cost of capital and lower valuations, all else equal. Post debt issuance, both Aquarius & Bema will have identical EBIT and leverage (debt/equity 0.6) as stated. The question states that marginal corporate tax rates are also identical. Hence the conclusion that Bema’s value will decrease relative to Aquarius implies that Bema’s WACC will be higher. If Bema has higher bonding costs (option A) or lower percentage of tangible assets ©, it will be relatively riskier and will have a higher WACC compared to Aquarius. Hence both these options are consistent with the conclusion. If Bema had lower operating leverage (B), it would be relatively less risky (given that financial leverage is the same) with a lower WACC / higher valuation. This is inconsistent with the conclusion and hence the correct answer is B.
thanks oz. basically just remember higher operating leverage is riskier and thus WACC goes up so firm value goes down and vis-versa.