You are considering a new product launch. The project will cost $2,350,000, have

Question

You are considering a new product launch. The project will cost $2,350,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 150 units per year; price per unit will be $31,000, variable cost per unit will be $19,000, and fixed costs will be $620,000 per year. The required return on the project is 14 percent, and the relevant tax rate is 34 percent.

a. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within ±10 percent. What are the upper and lower bounds for these projections? What is the base-case NPV? What are the best-case and worst-case scenarios?

b. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.

c. What is the cash break-even level of output for this project (ignoring taxes)?

d-1 What is the accounting break-even level of output for this project?

d-2 What is the degree of operating leverage at the accounting break-even point?

Explanation / Answer

Answer for question no.a:

Cost of the project =$2,350,000.

Life of the project = 4 years.

Salvage value = 0.

Depreciation is to be calculated on straight line basis. Formula for straight line method of depreciation = (Cost of the project - salvage value)/Life of the project

=($2,350,000- 0)/4

=$587,500.

Base case NPV:

Cost of capital =14%.

Annuity value for 4 year @14% = 1-(1+r)-n/r

=1-(1+.14)-4/.14

=2.9137.

NPV = Present value of cash inflows - Present value of cash outflows.

=Annual cash inflows * Annuity factor - Present value of cash outflows..

=2.9137 * $978,550

=$2,851,201.14 -$2,350,000

=$501,201.14.

Answer for question no.b:

Answer for question no.c.:

Cash break even level of output for the project.

(Fixed expenses - Non cash fixed expenses)/Contribution

In the present case base case fixed expenses excluding depreciation =$620,000

Contribution per unit =$31,000 -$19,000

=$12,000

Therefore, cash break even level of output =$620,000/$12,000

=51.67 units rounded to 52 units.

Answer for question no.d1:

Accouting break even level of output is the output at which the contribution earned is equal to fixed expenses.

=Total fixed expenses/Contribution per unit

Total fixed expenses =$1,207,500

=$1,207,500/$12,000

=100.63 rounded to 101 units.

Particulars 150 units Best case +10% i.e., Base case* 110% Worst case -10% i.e., Base case *90% Sales (A) $4,650,000.00 $5,115,000.00 $4,185,000.00 Minus: Variable cost (B) $2,850,000.00 $3,135,000.00 $2,565,000.00 Contribution (C )=A-B $1,800,000.00 $1,980,000.00 $1,620,000.00 Minus: Fixed cost (D) $620,000.00 $682,000.00 $558,000.00 Minus: Depreciation (E ) $587,500.00 $587,500.00 $587,500.00 Total fixed cost (F) = (D)+ (E ) $1,207,500.00 $1,269,500.00 $1,145,500.00 Net income (G) =(C ) - (F) $592,500.00 $710,500.00 $474,500.00 Tax @34% =(H) = (G) *34% $201,450.00 $241,570.00 $161,330.00 Income after tax (I) $391,050.00 $468,930.00 $313,170.00 Add: Depreciation (E ) $587,500.00 $587,500.00 $587,500.00 Annual cash inflow (J) = (I)+(E ) $978,550.00 $1,056,430.00 $900,670.00

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