Hi! Please answer :) I\'d appreciate if someone could give me a thorough explana

Question

Hi! Please answer :) I'd appreciate if someone could give me a thorough explanation and not just copy and past textbook answers, similar problems or someone elses answers. I'd like to know how to do this SPECIFIC problem. Thank you!!!!

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Schweser Satellites Inc. produces satellite earth stations that sell for $95,000 each. The firm's fixed costs, F, are $2.5 million, 50 earth stations are produced and sold each year, profits total $400,000; and the firm's assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $3 million to investment and $540,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $12,000 and (2) increase output by 19 units, but (3) the sales price on all units will have to be lowered to $87,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 14%, and it uses no debt.

A) What is the incremental profit?
$

C) Would the firm's break-even point increase or decrease if it made the change? Choose answer:
-1.CHANGE WOULD INCREASE THE BREAK-EVEN POINT

-2.CHANGE WOULD DECREASE THE BREAK-EVEN POINT

D) Would the new situation expose the firm to more or less business risk than the old one?CHOOSE ANSWER BELOW:

I. The new situation would obviously have less business risk than the old one.

II. It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one.

III. The new situation would obviously have more business risk than the old one.

Explanation / Answer

I liked the disclaimer at the beginning :)

A. New production volume = 50+19 = 69

New sales = 69*87,000 = 6,003,000

Old contribution/unit = (profit+fixed cost)/no of units = (400,000+2,500,000)/50 = 58,000

Old variable cost/unit = 95,000-58,000 = 37,000

So new variable cost/unit = 37,000-12,000 = 25,000

New profit = new units *(new sales price-new variable cost/unit) - new fixed price = 69*(87,000-25,000)-(2,500,000+540,000) = 1,238,000

Incremental profit = new profit-old profit = 1,238,000-400,000 = 838,000

Project's rate of return = 838,000/3,000,000 = 27.93%

B. As the rate of return is greater than the cost of equity of 14%, the firm should proceed with the investment. Answer is YES.

C. Old contribution margin ratio = old contribution/old sales price = 58,000/95,000 = 61.05%

Old breakeven point (in sales dollars) = old fixed cost / old contribution margin ratio = 2,500,000 / 61.05% = 4,094,828

New contribution margin ratio = new contribution/new sales price = (87,000-25,000)/87,000 = 71.26%

New breakeven point (in sales dollars) = new fixed cost / new contribution margin ratio = (2,500,000+540,000) / 71.26% = 4,265,806

So the change would increase the breakeven point.

D. It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one.

This is because while the breakeven point has increased, the potential demand has also increased (along with the increased ROE of 15.48%, up from the old ROE of 8%) and hence these may need to be examined in closer detail, along with other factors such as better balance sheet owing to the greater profits being generated now. However, there are multiple perspectives on this issue, and people can argue any of the 3 given alternatives is right.

Hope this helped ! Let me know in case of any queries.

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