Activity 1: Discussion: Types of risks, types of leverage Financial leverage is not the only type of leverage and financial risk is not the only type of risk for the firm. In lecture and online module we briefly introduced sales risk and operating risk, which jointly is called business risk. In groups, briefly consider these questions: 1) Can you think of industries with a. high vs. low sales risk? b. high vs. low operating risk, i.e., which industries face (relatively speaking) more fixed costs, which more variable costs? 2) Holding everything else constant, what are the combined effects of sales and operating risk on the ex- ante capacity for financial risk (financial leverage) of the firm? Can you see where some companies derive a competitive advantage? How could companies actively work towards increasing this advantage? Activity 2: Perpetuities and levered return on equity Ice Cream Machines Inc. regularly achieves an EBIT of $10m per year, faces a cost of unlevered equity of 9% and is subject to a 28%% tax rate. XYZ Partners, a cut-throat private equity firm, is considering a so-called leveraged buyout, a magic little trick in the world of finance: They buy the target firm with mostly debt (and a little bit of their own money) and saddle the company with the debt, while paying themselves high dividends. Assume XYZ convinces a consortium of banks to lend them $60.6m at 4%, what will the equity in the target firm be worth to XYZ? What will be their annual return based on the value of the equity if they pay out all net income in the form of dividends? What else does this number tell you? Confirm your intuition. One of the key benefits of the LBO is the lowering of overall cost of capital. Confirm this as well. Activity 3: Longer MM problem & degrees of leverage Nik Nak Enterprises sells widgets for $10 a piece which cost them $6 to make. In a good year (probability 50%), the company sells 150,000 widgets and in a bad year only 100,000. The company faces fixed costs of $200,000. The corporate tax rate is 30%. The company can borrow at 8% and the unlevered equity has a required rate of return of 12%. 1) Populate a very basic pro-forma income statement for the bad and the good year for the unlevered firm. 2) Compute the value of the unlevered firm under the perpetuity assumption