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 $6 million. The firm estimates that it can change its production process, adding $5 million to investment and $350,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $9,000 and (2) increase output by 19 units, but (3) the sales price on all units will have to be lowered to $90,000 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.
   %
   Should the firm make the investment?
   -Select-YesNo
   
2. Would the firm's break-even point increase or decrease if it made the change?
   -Select-The change would increase the break-even point.The change would decrease the break-even point.
   
3. Would the new situation expose the firm to more or less business risk than the old one?
   -Select-IIIIII
   I. The new situation would obviously have less business risk than the old one.
   II. It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one.
   III. The new situation would obviously have more business risk than the old one.

Answer 1

a. Incremental Profit :

Profit before Investment:   

	Per unit	Old (50 units)
Sales	95000	4750000
Variable Cost	47000	2350000
Fixed Cost		2000000
Profit		400000

Profit after Investment :

	Per unit	New (69 Units)
Sales	90000	6210000
Variable Cost	38000	2622000
Fixed Cost		2350000
Additional cost on equity	=5000000*16%	800000
Profit		438000

Thus, there is incremental profit of 438000-400000=$38000.

Project's Expected Rate of return = Incremental Profit + cost on equity / Incremental Investment

=38000+800000 / 5000000 = 16.76%

b. Break Even Point : = Fixed Cost / Contribution per unit

BEP before Investment :

	Per unit	Old (50 units)
Sales	95000	4750000
Variable Cost	47000	2350000
Contribution	48000	2400000
Fixed Cost		2000000
Profit		400000
BEP	=2000000/48000	41.67

BEP after Investment :

	Per unit	New (69 Units)
Sales	90000	6210000
Variable Cost	38000	2622000
Contribution	52000	3588000
Fixed Cost		2350000
Additional cost on equity	=5000000*16%	800000
Profit		438000
BEP	=2350000/52000	45.19

Thus, Break Even Point will increase by 45.19-41.67 = 3.53 Units.

C. (III) The new situation would obviously have more business risk than the old one.

Because of Increased Fixed cost and increased Break even point, Business risk will increase in new situation.

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