DescriptionMGMT 6360 OM Quiz 5

Name:

1. A lab is trying to determine how many test kits it should order from its supplier. They use 780

kits per year (D). The annual holding cost is $3 per kit per year (H). The ordering cost is $15

per order (S). The supplier delivers their orders all at one time but offers a quantity discount.

Draw the Order quantity (Q) verses Total Annual Cost graph with 3 item prices (as shown in

Figure 12.7 of the textbook). What is the optimum condition (order quantity and item price)?

What is the total annual cost (holding cost + ordering cost + item cost)?

Quantity

1-72

73-144

145 and more

$Price

60

56

53

EOQ= sqrt (2* demand * ordering cost/ holding cost) = 88.317= 88

Q*= Adjusting quantity between the upper and lower limit and the EOQ

Annual holding costs = (Q */2) * holding cost per unit= 88/2 * 3 = 132

Annual ordering cost = (demand/Q*) * ordering cost = (780/88) * 15= 132.95

Annual purchasing cost = demand * Q = 780 * 56= $43,680

Total cost of inventory = annual holding cost + annual ordering cost + annual purchasing cost +

$43,947

1

2. A city wants to promote annual marathon event by ordering and selling T-shirts. Sales price is

$12.95, Cost is $5.00, and Salvage value is $0.50. From previous years’ sales history the

following data is available. Setup the payoff table with expected profit. How many T-shirts

should they order and stock?

Demand

75,000

80,000

85,000

90,000

95,000

Probability

5%

20%

25%

30%

20%

Payoff = demand (selling price- unit cost)

When the number of shirts ordered is less than the demand the payoff is calculated as

Payoff = (number of items demanded) x (selling price – item cost) – (items ordered – items

demanded) x ( item cost – item salvage value)

DEMAND

Ordered

75,000

80,000

85,000

90,000

95,000

Expected

profit

$596,250.00

$632,887.50

$657,075.00

$665,700.00

$655,650.00

75,000

596,250

596,250

596,250

596,250

596,250

80,000

573,750

636,000

636,000

636,000

636,000

85,000

551,250

613,500

675,750

675,750

675,750

90,000

528,750

591,000

653,250

715,500

715,500

95,000

506,250

568,500

630,750

593,000

755,250

Probability 0.05

0.2

0.25

0.3

0.2

(x)

When we review the table above, put of all the expected profits for each of the possible ordered

quantities, we selected the order quantity with the highest expect profit/optimal profit which in

this case the city should order 90,000 shirts because it has an expect profit of $665,700.

2

FINA 6340 Advanced Corporate Finance

Case 32. California Pizza Kitchen

1. Read and briefly summarize the case. What is going on at CPK? What decisions does Susan

Collyns face?

2. The four alternatives considered explicitly in the case are

1) Maintain existing financial policy with no debt;

2) Borrow $23 million (10% debt to total book capital);

3) Borrow $45 million (20% debt to total book capital);

4) Borrow $68 million (30% debt to total book capital).

Using the scenarios in case Exhibit 32.9, what role does leverage play in affecting the return

on equity (ROE) for CPK? If the EBIT line is multiplied by a factor of 1.5, how will be the

effect of leverage on the risk of equity returns different, compared to the base case? If the

EBIT line is multiplied by a factor of 0.5, how will be the effect of the risk of equity returns

different, compared to the base case?

California Pizza Kitchen

Pro Forma Tax Shield Effect of Recapitalization Scenarios

(dollars in thousands, except share data; figures based on end of June 2007)

Interest rate

Tax rate

Earnings before income taxes and interest

Interest expense

Earnings before taxes

Income taxes

Net income

Book value:

Debt

Equity

Total capital

Return on equity

Actual

6.16%

32.5%

30,054

0

30,054

9,755

20,299

Debt/Total Capital

10%

20%

30%

6.16%

6.16%

6.16%

32.5%

32.5%

32.5%

30,054

30,054

30,054

1,391

2,783

4,174

28,663

27,271

25,880

9,303

8,852

8,400

19,359

18,419

17,480

0

225,888

225,888

8.9%

22,589

203,299

225,888

9.5%

45,178

180,710

225,888

10.2%

67,766

158,122

225,888

11%

FINA 6340 Advanced Corporate Finance

3. Using the scenarios in case Exhibit 32.9, what role does leverage play in affecting the cost of

equity and the weighted average cost of capital (WACC) for CPK? Use market values of debt

and equity to compute the cost of equity and WACC.

California Pizza Kitchen

Pro Forma Tax Shield Effect of Recapitalization Scenarios

(dollars in thousands, except share data; figures based on end of June 2007)

Interest rate

Tax rate

Earnings before income taxes and interest

Interest expense

Earnings before taxes

Income taxes

Net income

Actual

6.16%

32.5%

30,054

0

30,054

9,755

20,299

Debt/Total Capital

10%

20%

30%

6.16%

6.16%

6.16%

32.5%

32.5%

32.5%

30,054

30,054

30,054

1,391

2,783

4,174

28,663

27,271

25,880

9,303

8,852

8,400

19,359

18,419

17,480

Book value:

Debt

Equity

Total capital

0

225,888

225,888

22,589

203,299

225,888

45,178

180,710

225,888

67,766

158,122

225,888

Market value:

Debt

Equity

Market value of capital

0

643,773

643,773

22,589

628,516

651,105

45,178

613,259

658,437

67,766

598,002

665,769

9.5%

9.5%

10%

9.8%

1.1%

10.7%

2.29%

20.6%

Cost of equity

WACC

4. What capital structure policy would you recommend for CPK?

After crunching the numbers, it can be concluded that it would be best for Susan to accruing debt

for the company. Such leverage has a strong potential to increase the pizza company’s ROE and

share price. There are a couple of things to note, however, because the company also has an

expansion plan of $85 million, they must be aware that borrowing more than they can afford can

cripple their cashflow and lead them to bankruptcy.

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