16. Betas and operating leverage (S9.3) You run a perpetual encabulator machine, which generates revenues averaging $20 million per year. Raw material costs are 50% of revenues.

These costs are variable—they are always proportional to revenues. There are no other operating costs. The cost of capital is 9%. Your firm’s long-term borrowing rate is 6%. Now you are approached by Studebaker Capital Corp., which proposes a fixed-price contract to supply raw materials at $10 million per year for 10 years.

a. What happens to the operating leverage and business risk of the encabulator machine if you agree to this fixed-price contract?

b. Calculate the present value of the encabulator machine with and without the fixed-price contract.