Answer A

According to the free cash flow valuation model, the value of the company is
Value of the company = Sum of the present value of the free cash flow
∞
FCF T
V 0= ∑ T
T =1 ( 1+WACC )

If the FCF of the company grows at the constant growth rate, g then the value of the company
will be
FCF 0 (1+ g)
V 0=
(WACC−g)

Where,
V0 = Value of the company
FCF = Free cash flow of the company
WACC = Weighted average cost of capital
From the above equation, it can be seen that the value of the firm is largely determined by the
WACC of the company, and the WACC is dependent on the capital structure of the company.
The portion of debt and equity in the capital structure largely determines the WACC as it is
calculated as
WACC = Weight of Debt x Cost of Debt + Weight of Equity x Cost of Equity
The firm’s capital structure decision will have the impact on the weight of debt and equity
which in turn will affect the WACC of the company. As the WACC increases, the value of the
firm decreases and as WACC decreases the value of the firm increases.

Answer B
a. Business risk is the risk associated with the uncertainty in the earnings before interest
and tax. Business risk refers to the possibility of the business to generate lower profits
due to uncertainties. It is the exposure of a company to the factors that will affect the
ability of the company to generate profits. Several factors affect the business risk as
i. Demand uncertainty affecting the sales
ii. Uncertainty in the prices of the output as well as the input costs
iii. Liability associated with product and all other types of liability
iv. Degree of operating leverage.
b. Operating leverage is the degree with which the EBIT of the company changes with the
change in the quantity sold. The operating leverage increases if the company have the
high proportion of fixed costs in the cost structure of the company which indicates the
higher business risk as a slight decrease in the sales will lead to larger decline in the
EBIT.
Breakeven point = Fixed cost/(Selling Price – Variable cost)
Breakeven point = 200/(15 – 10)
Breakeven point = 40
So, the company’s operating breakeven point is 40 units.
Conclusion
From the case, it can be concluded that the leverage will affect the ROE of the company. When
two firms having same level of sales, assets, and EBIT, one with no leverage and another with
leverage, are compared, it can be seen that the leveraged firm has higher net income resulting
to higher ROI and ROE. However, the basic earning power of the firm remains unaffected for
both the firms. The tax saving due to interest for the leveraged firm increases the expected
profitability to the shareholders. However, it should be noted that the ROE will only increase
with the use of debt only if ROA exceeds the after-tax cost of debt.