EXERCISE 6-17 (30 MINUTES)

3. The major factor would be the sensitivity of the company’s operations to

cyclical movements in the economy. In years of strong economic activity,

the company will be better off with the new equipment. The reason is

that the new equipment will increase the CM ratio, permitting profits to

rise more rapidly in years that sales are strong. However, in periods of

economic recession, the company will be worse off with the new equip-

ment. The greater fixed costs created by the new equipment will cause

losses to be deeper and sustained more quickly than at present. Thus,

management must decide whether the potential for greater profits in

good years is worth the risk of deeper losses in bad years.