Question

Break-even Point Schweser Satellites Inc. produces satellite earth stations that sell for $95,000 each. The firm's fixed costs, F, are $2.5 million, 50 earth stations are produced and sold each year, profits total $400,000, and the firm's assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $5 million to assets and $570,000 to fixed operating costs. This change will reduce variable costs per unit by $12,000 and increase output by 20 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 13%, and it uses no debt.

What is the incremental profit? 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? ??

Answer 1

Before Investment

Total Assets = $5 million (all equity)

Revenue = $95000/station *50 station =$4,750,000

Less: Fixed Cost = $2,500,000

Less: Variable Cost = (4750000-2500000-400000 (profit)) =$1,850,000

Profits = $400,000

So, Variable cost per unit =1850000/50 = $37000

If Investment is done

Total Assets = $10 million (all equity)

Revenue = $89000/station *70 station =$6,230,000

Less: Fixed Cost = $2,500,000+ $570,000 = $3,070,000

Less: Variable Cost = ($37000-$12000) * 70 =$1,750,000

Profits = $1,410,000

So Incremental profit = $1410000 -$400000 =$1,010,000

Project's Expected Rate of Return = Incremental profit/Incremental Investment

=1010000/5,000,000

=0.2020

=20.20%

As the expected return is greater than the cost of capital of 13% , the project should be undertaken i.e. investment should be done.