Fundamentals of Financial Management (Concise 6th Edition)

Chapter 13 Capital Structure and Leverage 407

Thus, for Plan A,

QBE! _____$20,000
$2.00 " $1.50
! 40,000 units

And for Plan B,

QBE! _____$60,000
$2.00 " $1.00
! 60,000 units

How does operating leverage affect business risk? Other things held constant, the
higher a! rm’s operating leverage, the higher its business risk. This point is demon-
strated in Figure 13-3, where we develop probability distributions for ROE under
Plans A and B.
The top section of Figure 13-3 graphs the probability distribution of sales that
was presented in tabular form in Figure 13-2. The sales probability distribution
depends on how demand for the product varies, not on whether the product is
manufactured by Plan A or by Plan B. Therefore, the same sales probability distri-
bution applies to both production plans. This distribution has expected sales of
$200,000; and it ranges from zero to about $400,000, with a standard deviation of
$Sales " $98,793.

Note: We are using continuous distributions to approximate the discrete distributions contained in Figure 13-2.

Analysis of Business Risk

F I G U R E 1 3! 3

Probability

Density

0 $200,000

(Expected Sales)

Sales ($)

a. Sales Probability Distribution

Under Either Plan A or B

0 9 12 ROE (%)

(Expected

ROEA)

(Expected

ROEB)

Probability

Density

Plan B

Plans A and B

Plan A

b. ROE Probability Distribution