Question

A. Why do labor-intensive processes involve less operating leverage than automated processes? What fixed cost are associated with automation? Why cant those cost be eliminated by just selling the machinery?

B. Explain the idea of bankruptcy cost. Why are they important to investors? when do investors start to worry about them?

Answer 1

A. Why do labor-intensive processes involve less operating leverage than automated processes? What fixed costs are associated with automation? Why can’t those costs be eliminated by just selling the machinery?

The labor-intensive processes involve less operating leverage than automated processes because operating leverage is associated with the amount of fixed cost. Labor-intensive processes are less costly therefore break-even point can be reached early while the automated processes are more costly than it takes more time to reach at break-even point. The unit contribution is more in automated processes due to high fixed costs. The fixed costs that associated with automation are expenditures for equipment, tools, training, etc. Those costs can’t be eliminated by just selling the machinery because machinery get depreciated with the time and its book value get reduced and other costs like training cannot be recovered.

B. Explain the idea of bankruptcy cost. Why are they important to investors? When do investors start to worry about them?

A bankruptcy cost of the firm is the expected costs of financial distress. it can be understood by the following formula-

Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected Bankruptcy Cost from the Debt)

The Bankruptcy cost is important to investors because it has impact on the value of the firm therefore on the stock of the company. In bankruptcy situation, generally firm either goes for liquidation of business (pay the money to creditors and other stakeholders) or restructuring the business so that it can come out from the present money crisis. They examine the pros and cons of both options and often give up their debt in exchange for shares of common stock to reduce the burden of paying fixed cash in the form of principal and interest to the creditors. Investors do start to worry about them when expected bankruptcy cost from the debt is more than the tax benefits of debt because it that situation the value of firm will be less than its unlevered value.