Break-even Point Schweser Satellites Inc. produces satellite earth stations that
ID: 2731719 • Letter: B
Question
Break-even Point Schweser Satellites Inc. produces satellite earth stations that sell for $95,000 each. The firm's fixed costs, F, are $2 million, 50 earth stations are produced and sold each year, profits total $500,000; and the firm's assets (all equity financed) are $4 million. The firm estimates that it can change its production process, adding $4 million to investment and $360,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $9,000 and (2) increase output by 25 units, but (3) the sales price on all units will have to be lowered to $90,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 16%, and it uses no debt.
What is the incremental profit? $
To get a rough idea of the project's profitability, what is the project's expected rate of return for the next year (defined as the incremental profit divided by the investment)? Round your answer to two decimal places. %
Should the firm make the investment?
Would the firm's break-even point increase or decrease if it made the change?
Would the new situation expose the firm to more or less business risk than the old one? 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
First, we need to find the variable costs per unit by putting all the information given in the equation below with the number in bold. We will get the sales per year and total contribution margin before working back to variable costs per unit.
Data:
Sales = $95000 x 50 units 4750000
Total Variable Costs ($45000 x 50 units) 2,250000
Total Contribution Margin = Sales - Total VC = $2,500,000
Total Fixed Costs 2,000,000
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Net Income = Total CM - Total FC = $500,000
Now, company adding $4 million to investment and $360,000 to fixed operating costs
New result will be:
Sales ($90,000 x (50 + 25 units)) 6,750,000
Total Variable Costs (($45000 - $9,000) x 75 units) 2,800,000
Total Contribution Margin = Sales - Total VC 3,850,000
Total Fixed Costs ($2,000,000 + $360000) 2,360000
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Net Income = Total CM - Total FC = 1,490,000
Result of change is increase in Net Income.
Increase in Net income = $1,490,000 - $ 500,000 = $990000per year.
Thus, company should make the investment.
project’s expected rate of return (defined as the incremental profit divided by the investment) = $990000/ $4000000 = 0.2475= 24.75%
Calculation of BEP:
BEP before change:
Q = F/(P-V)
Where
F = fixed costs
P = price
V = variable costs
So, Q = $2,000,000/ ($95000 - $50000) = 44.44 units
BEP after change :
Q = $2360000 / ($90000 - $36,000) = 43.70 units
Clearly, company has to sell almost equal units to Break Even if company makes change.
Answer C)
Usually higher degree of operating leverage means more business risk. In this case, company achieves higher degree of operating leverage by making change, so company exposes itself to more business risk by making changes.
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