Question

Break-Even Point Schweser Satellites Inc. produces satellite earth stations that sell for $105,000 each. The firm's fixed costs, F, are $1 million, 50 earth stations are produced and sold each year, profits total $400,000, and the firm's assets (all equity financed) are $4 million. The firm estimates that it can change its production process, adding $3 million to assets and $400,000 to fixed operating costs. This change will reduce variable costs per unit by $12,000 and increase output by 15 units. However, the sales price on all units must be lowered to $100,000 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. What is the incremental profit? Enter your answer in dollars. For example, an answer of $4 million should be entered as 4,000,000, not 4. Round your answer to the nearest dollar. $   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? -Select-YesNoItem 3 Would the firm's break-even point increase or decrease if it made the change? The change would -Select-increasedecreaseItem 4 the break-even point. Would the new situation expose the firm to more or less business risk than the old one? I. The new situation would obviously have more business risk than the old one. II. The new situation would obviously have less business risk than the old one. III. It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one. -Select-IIIIIIItem 5

Answer 1

Old process
Selling price, P	105000
Fixed costs, F	1000000
Sales, S	50
Profits, C	400000
Variable costs	77000	(P - (C+F)/S)
New process
Selling price, P	100000
Fixed costs, F	1400000
Sales, S	65
Variable costs	65000
New profits	875000
Incremental profit	475000
Expected rate of return	15.83%	475000/3000000
Since expected rate of return is more than cost of equity, it should make the investment
Earlier breakeven point	35.71		Fixed costs / (Price - Variable costs)
New break even point	40.00
So break even point increases
Due to significant increase in fixed costs, the new situation would obviously have more business risk than the old one.