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 million, 50 earth stations are produced and sold each year, profits total $400,000; and the firm's assets (all equity financed) are $4 million. The firm estimates that it can change its production process, adding $3.5 million to investment and $370,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $12,000 and (2) increase output by 21 units, but (3) the sales price on all units will have to be lowered to $85,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 16%, 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

Calculate variable cost per unit:

Number of units (n)	50
Price/unit (p)	95,000
Total sales (S = p*n)	4,750,000
Less: Fixed cost (fc)	2,000,000
Less: Profit (P)	400,000
Variable cost (vc = S -fc -P)	2,350,000
Variable cost/unit (vc/n)	47,000

Profit if the production process is changed:

Increase of 21 units	Number of units (n)	71
Reduction to 85,000	Price/unit (p)	85,000
Reduction of 12,000	Variable cost/unit (vc)	35,000
	Contribution margin (cm = p-vc)	50,000
	Total (T = n*cm)	3,550,000
Increase of 370,000	Less: Fixed cost (fc)	2,370,000
(T-fc)	Profit (P)	1,180,000

a). Incremental profit = new profit - current profit = 1,180,000 - 400,000 = 780,000

b). Additional investment required = 3,500,000

ROI = Incremental profit/Additional investment = 780,000/3,500,000 = 22.29%