Question

Gamut Satellite Inc. produces satellite earth stations that sell for $150,000 each. The firm’s fixed costs, F, are $1.5 million, 20 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 $10 million to assets and $500,000 to fixed operating costs. This change will reduce variable costs per unit by $5,000 and increase output by 30 units. However, the sales price on all units must be lowered to $140,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 18%, and it uses no debt.

a. Determine the variable cost per unit

b. Determine the new profit if the change is made

c. What is the incremental profit?

d. What is the projects expected rate of return for the next year (defined as the incremental profit divided by the investment)?

e. Should the firm make the investment? Why or why not?

f. Would the firm’s break-even point increase or decrease if it made the change?

g. Would the new situation expose the firm to more or less business risk than the old one? Show workings

Answer 1

Under old Situation:

S.No	Particulars	Amount
A	Sale Price Per Unit	$150,000
B	No,of Units sold	20
C	Sale value( A*B)	$3,000,000
D	Variable Cost*	$1,100,000
E	Contribution( F+G)	$1,900,000
F	Fixed Cost	$1,500,000
G	Profit	$400,000

We know that Fixed Cost + Profit = Contribution

Contribution = $ 15,00000+$ 400000

Contribution = $ 19,00000

Contribution per unit = Total Contribution / No.of Units

= $ 19,00000/$ 20

= $ 95000

We also know that Sales - Variable Cost = Contribution

$ 30,00000- Variable Cost = $ 19,00000

Variable Cost = $ 11,00000

Variable Cost per unit = Total Varaible Cost / No.of Units

= $ 11,00000/20

= $ 55000

Hence Variable Cost per unit is $ 55000

Under Revised Situation

S.No	Particulars	Amount
A	Sale Price Per Unit	$140,000
B	No,of Units sold	50
C	Sale value( A*B)	$7,000,000
D	Variable Cost per unit	$50,000
E	Total Variable Cost ( B*D)	$2,500,000
F	Contribution( C-E)	$4,500,000
F	Fixed Cost	$2,000,000
G	Profit( E-F)	$2,500,000

Contribution per unit = Total Contribution / No.of units

= $ 45,00000/50

= $ 90,000

a) Variable cost under old situation = $ 50,000

New Varaible Cost per unit = $ 55000-$ 5000= $ 50,000

b) New Profit if the Change is made = $ 25,00000

c)Incremental profit = New Profit - Old Profit

= $ 25,00000-$ 400000

= $ 21,00000

Incremental profit = $ 21,00000

d) Projects Expected rate of return = Incremental profit/ Incremental investment

= $ 21,000000/$ 100,00000

=21%

Hence Projects Expected return is 21%

e) Expected return on the project i.e 21% is greater than Cost of equity i.e 18%. Hence it is advisable for the firm to make the investment

f)

S.No	Particulars	Old Situation	Revised Situation
A	Fixed Cost	$1,500,000	$2,000,000
B	Contribution per unit	$95,000	$90,000
C	Break Even Sales( A/B)	15.79	22.22

Break even sales under the old situation = 15.79 units

Break Even sales under the new situation = 22.22 units

Firms Break even sales increases due to change made

g) Contribution reduces by $ 5000 under the revised situation.Increase in the Break evven sales and reduction in the Contribution per unit would put a business concern more riskier than previous one.

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