Question

Tank Co. is evaluating a project that costs $100,000 and has a 5-year life. Assume that depreciation is prime-cost to zero salvage value over the 5-years, and the equipment can be sold for $6,000 at the end of year 5. The average discount rate for such a project is 10 per cent on such projects. The individual tax rate is 15 per cent and the corporate tax rate is 30 per cent. It is projected that they will sell 12000 units per year. Price per unit is $12, the variable cost per unit is $3 and fixed costs are $21,000 per year. (a) Calculate the accounting break-even point and cash break-even point. [3 marks] (b) What is the degree of operating leverage at the accounting breakeven point? [3 marks] (c) What is the estimated NPV for the project, and should Tank accept the project? [4 marks]

Answer 1

Accounting Breakeven point = ( Fixed costs + depreciation) / ( Selling price - variable cost)

Depreciation =( historical cost - salvage value ) / useful life

= (100000 - 0 ) / 5 = 20000

Accounting Breakeven point = ( 21000 + 20000 ) / ( 12 -3) = 41000 / 9 = 4555.56 units per year

Cash breakeven point = ( Total fixed costs - deprecciation ) / ( Selling price - varaible cost)

= 21000 / ( 12 - 9)

= 2333.33 units per year

b)

Operating leverage = contirbution / earning before interest and tax

= ( Selling price - variable cost )* no of units / [ ( Selling price - variable cost )* no of units - fixed costs)

= ( 12-3)* 4555.56 / [ ( 12-3)*4555.56 - 41000

= 41000 / [ 41000 - 41000]

= 0

c)

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

Year	0	1	2	3	4	5	5	Total
Selling price(A)		12	12	12	12	12
variable cost (B)		3	3	3	3	3
contribution (C= A- B)		9	9	9	9	9
no of units (D)		12000	12000	12000	12000	12000
Total contribution (E = C*D)		108000	108000	108000	108000	108000
Fixed costs (F)		21000	21000	21000	21000	21000
Depreciation (G)		20000	20000	20000	20000	20000
EBIT (H = E - F-G)		67000	67000	67000	67000	67000
Tax (I = H *30%)		20100	20100	20100	20100	20100
PBT ( J =H -I)		46900	46900	46900	46900	46900
Depreciation (K)		20000	20000	20000	20000	20000
Cash flow ( L = J + K)		66900	66900	66900	66900	66900
Salvage value		0	0	0	0	0	6000
Equipment cost	-100000
Discounting Factor ( M = 1/(1+R)^N	1	0.909090909	0.826446281	0.751314801	0.683013455	0.620921323	0.620921323
Present value	-$100,000.00	$60,818.18	$55,289.26	$50,262.96	$45,693.60	$41,539.64	$3,725.53	$157,329.16

NPV = $157,329.16

Tank should accept the project.