Question

1. Break-even analysis To be profitable, a firm has recover its costs. These costs include both its fixed and its variable costs. One way that a firm evaluates at what stage it would recover the invested costs is to calculate how many units or how much in dollar sales is necessary for the firm to earn a profit. Consider the case of Petrox Oil Co.: Petrox Oil Co. is considering a project that will have fixed costs of $15,000,000. The product will be sold for $37.50 per unit, and will incur a variable cost of $10.75 per unit. Given Petrox’s cost structure, it will have to sell units how many to break even on this project?  Petrox’s marketing and sales director doesn’t think that the firm’s market is big enough for the firm to break even. In fact, she believes that the firm will be able to sell only about 200,000 units. However, she also thinks that the demand for Petrox’s product is relatively inelastic (so the firm can increase the sales price without significantly decreasing the volume of product sold). Assuming that the firm can sell 200,000 units, what price must it set to break even? $85.75 per unit $81.46 per unit $102.90 per unit $94.33 per unit.

2. What affects the firm’s operating break-even point? Several factors affect a firm’s operating break-even point. Based on the scenarios described in the following table, indicate whether these factors would increase, decrease, or leave unchanged a firm’s break-even quantity—assuming that only the listed factor changes and all other relevant factors remain constant. Increase Decrease No Change The firm depreciates its fixed assets more quickly over a shorter life. The variable cost per unit decreases. The amount of debt increases, causing the firm’s total interest expense to increase.

3. When other things are held constant, the higher a firm’s operating leverage, the higher or lower will be its business risk?

Answer 1

1).

Given Fixed costs are 15000000. Price is 37.5 per unit and variable cost is 10.75 per unit. Let x be the number of units to be sold to achieve breakeven. At breakeven point, Revenue will be exactly equal to sum of Total Fixed costs and Total Variable costs.

So, 37.5*x= (10.75*x)+15000000

26.75x= 15000000

x= 560747.66

So, The firm need to sell 560748 units to achieve breakeven

Given that the firm can sell 200000 units. Let x be the price at which there will be breakeven. So, 200000*x= (200000*10.75)+15000000

200000*x= 17150000

x= 85.75 (Option A)

2).

If the firm depreciates its assets quickly, its depreciation expense increases. As its an operating expense, it affects the breakeven quantity. As it increases, the breakeven point also increases.

Variable cost is directly associated with breakeven analysis. If variable cost decreases, breakeven point decreases.

The interest on debt is not considered as operating expense.So, it wont wont a breakeven point. Hence, no change.

3).

Higher the firm operating leverage, the more sensitive a company's earnings to change in sales, provided all other aspects held constant. Beacuse of this increases sensitivity, a firm's business risk is higher when a firm has higher operating leverage.