Question

We are evaluating a project that costs $864,000, has an eight-year life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 7,000 units per year. Price per unit is $49, variable cost per unit is $33, and fixed costs are $765,000 per year. The tax rate is 35 percent and we require a return of 10 percent on this project.

1-Calculate the accounting break-even point. And the financial break even . 2 points

2-Calculate the base-case cash flow arid NP\/. What is the sensitivity of NP\/ to changes in the sales figure? Explain what your answer tells you about a 500-unit decrease in projected sales.

3-What is the sensitivity of OCF to changes in the variable cost figure? Explain what your answer tells you about a $1decrease in estimated variable costs.

4- Scenario Analysis In the above problem, suppose the projections given for price, quantity, variable costs, and fixed costs are all accurate to within a+-10 per-cent. Calculate the best-case arid worst-case NPV figures

Answer 1

1. Accounting break-even = (FC + Depreciation) / (Price - VC) = (765,000 + 864,000 / 8) / (49 - 33) = 54,562.50 units

In order to calculate financial break even point, we need to build the NPV model. At financial break even point, NPV of the project is zero. We need to find quantity such that NPV = 0

We get when quantity = 59,751 => NPV = 0

	0	1-8
Investment	-864,000
Sales		2,927,799
VC		-1,971,783
FC		-765,000
Depreciation		-108,000
EBT		83,016
Tax (35%)		-29,056
Profit		53,960
Cash Flow	-864,000	161,960
NPV	$0

2.

	0	1-8
Investment	-864,000
Sales		343,000
VC		-231,000
FC		-765,000
Depreciation		-108,000
EBT		-761,000
Tax (35%)		266,350
Profit		-494,650
Cash Flow	-864,000	-386,650
NPV	($2,926,749)

Base Case cash flow = Profit + Depreciation = -386,650

Base case NPV = -2,926,749

Sensitivity of NPV can be calculated by calculating the change in NPV given a unit change in sales

NPV = -2,926,694 if unit sales = 7,001

=> Sensitivity = $55.48

For 500 unit change in sales, NPV change = $27,741.62

3) Similarly, if VC is increase by $1 to $34, new OCF = -4,550.00

Hence, $1 decrease in VC will increase OCF by $4,550.