Question

Problem 15-07
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 $5 million. The firm estimates that it can change its production process, adding $3 million to assets and $490,000 to fixed operating costs. This change will reduce variable costs per unit by $10,000 and increase output by 16 units. However, the sales price on all units must be lowered to $89,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 12%, and it uses no debt.

1. 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.
   %

Answer 1

Incremental Profit:

Incremental Profit = $574,000

Note:

1. Earth stations sold currently is 50. After additional investment, 16 additional units will be sold. Hence 50+16 = 66 units will be sold after investment (new).

2. Sale price currently is $95,000. The same is reduced to $89,000 across all units after additional investment

3. Fixed costs currently at $2 Million. Additional investment made is $490,000 and hence the new fixed cost is $2,490,000

4. Profit currently is $500,000.

Profit = Sales - Variable cost- Fixed Assets

Variable cost = Sales - Fixed Assets - Profit

= 4,750,000-2,000,000-500,000 = 2,250,000

Variable cost per unit = 2,250,000/50 = 45,000

After additional investment, Variable cost per unit reduces by 10000. Thus, new variable cost per unit = 45,000-10,000 = $35,000

Hence, total variable costs = New sales units * new variable cost per unit = 66*35000 = $2,310,000

5. Incremental = New - Existing

Workings

Expected rate of return:

Incremental profit = $574,000

Cost of equity = 12%

Present value of incremental profit = $574,000*(1/(1+12%)) = $574,000*0.892857 = $512,500

Expected rate of return = Present value of incremental profit / Additional investment in assets

=$512,500/$3,000,000 = 17.08%