A firm is about to double its assets to serve its rapidly growing mark

QUESTION

A firm is about to double its assets to serve its rapidly growing market. It must choose between a highly automated production process and a less automated one. It also must choose a capital structure for financing the expansion. Should the asset investment and financing decisions be jointly determined, or should each decision be made separately? How would these decisions affect one another? How could the leverage concept be used to help management analyze the situation?
The firm may want to assess the asset investment and financing decisions jointly. For instance, the highly automated process would require new equipment, so fixed costs would be high. A less automated production process, on the other hand, would be labor intensive, with high variable costs. If sales fell, the process which demands more fixed costs might be detrimental to the firm if it has much debt financing. The less automated process, however, would allow the firm to lay off workers and reduce variable costs if sales dropped; thus, debt financing would be¦

more attractive. Operating leverage and financial leverage are interrelated. The highly automated process would increase the firms operating leverage; thus, its optimal capital structure would call for less debt. On the other hand, the less automated process would call for less operating leverage; thus, the firms optimal capital structure would call for more debt.

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