Question

Break-even calculations are most often concerned with the effect of a shortfall in sales, but they could equally well focus on any other component of cash flow. Dog Days is considering a proposal to produce and market a caviar-flavored dog food. It will involve an initial investment of $90,000 that can be depreciated for tax straight- line over 10 years. In each of years 1 to 10, the project is forecast to produce sales of $100,000 and to incur variable costs of 50% of sales and fixed costs of $30,000. The corporate tax rate is 30%, and the cost of capital is 10%.

1. a) Calculate the NPV and accounting break-even levels of fixed costs.

2. b) Suppose that you are worried that the corporate tax rate will be increased immediately after you commit

   to the project. Calculate the break-even rate of taxes.

3. c) How would a rise in the tax rate affect the accounting break-even point?

Answer 1

		CALCULATION OF NPV
	I	Initial Cash Flow	($90,000)
	a	Annual Sales	$100,000
	b=a*50%	Annual Variable costs	$50,000
	c=a-b	Annual contribution margin	$50,000
	d	Annual Fixed Cost (excluding depreciation)	($30,000)
	e	Annual depreciation =90000/10	-$9,000
	f=c+d+e	Annual Operating Profit (Before Tax)	$11,000
	g=f*(1-0.3)	Annual Operating Profit after tax	$7,700
	h	Add: Annual Depreciation (Non Cash expense)	$9,000
	i=g+h	Annual Operating Cash Flow	$16,700
	Rate	Discount Rate =Cost of Captal	10%
	Nper	Number of years of cash inflow	10
	Pmt	Annual Operating cash flow	$16,700
	PV	Present Value of annual operating cash inflow	$102,614.27	(Using PV function of excel with Rate=10%, Nper=10, Pmt=-16700)
	NPV=PV+I	Net Present Value (NPV)	$12,614.27
		ACCOUNTING BREAKEVEN OF FIXED COST
	a	Annual contribution margin	$50,000
	b	Annual Depreciation	-$9,000
	c=a+b	Accounting Breakeven Fixed Cost	$41,000
	(b)	BREAKEVEN RATE OF TAXES
	a	Initial Investment	$90,000
	b	Required Present Value of Cash inflows	$90,000
	PMT	Annual after tax cash inflow required for breakeven	$14,647	(Using PMT function of excel with Rate=10%, Nper=10, Pv=-90000)
	c	Annual Depreciation	$9,000
	d=PMT-c	Annual after tax Operating Profit Required	$5,647
	e	Annual Before tax Operating Profit	$11,000
		11000*(1-Tax Rate)=5647
		BREAKEVEN RATE OF TAXES=1- (5647/11000)	0.486628587
		BREAKEVEN RATE OF TAXES=1- (5647/11000)	48.66%
	.(c)	A Rise in taxes will reduce the after tax accounting profit
		This will NOT affect the Break Even sales
		Break Even Sales =Fixed Cost/(Contribution Margin Ratio)
		These figures are not affected by tax rate