Question

Your company, which is financed entirely with common equity, plans to manufacture a new product, a cell phone that can be worn like a wristwatch. Two robotic machines are available to make the phone, Machine A and Machine B. The price per phone will be $260.00 regardless of which machine is used to make it. The fixed and variable costs associated with the two machines are shown below, along with the capital (all equity) that must be invested to purchase each machine. The expected sales level is 27,000 units. Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life of the project, so T = 0. How much higher or lower will the project's ROE be if you select the machine that produces the higher ROE, i.e., what is ROE_B - ROE_A? (Hint: Since the firm uses no debt and its tax rate is zero, ROE = EBIT/Required investment.)

	Machine A	Machine B
Price per phone (P)	$260.00	$260.00
Fixed costs (F)	$1,000,000	$2,000,000
Variable cost/unit (V)	$210.00	$160.00
Expected unit sales (Q)	27,000	27,000
Required equity investment	$2,500,000	$3,000,000

a. 7.75%

b. 7.84%

c. 9.33%

d. 11.20%

e. 8.87%

Answer 1

	Machine A	Machine B
Price per phone (P)	$260.00	$260.00
Fixed costs (F)	$1,000,000	$2,000,000
Variable cost/unit (V)	$210.00	$160.00
Expected unit sales (Q)	27,000	27,000
Required equity investment	$2,500,000	$3,000,000
EBIT	$350,000.00	$700,000.00
ROE	14.00%	23.33%
Difference in ROE	9.33%
Hence, the answer is c.9.33%

A Machine A 2 Price per phone (P) 260 3 Fixed costs (F) 1000000 4. Variable cost/unit (V) 210 5 Expected unit sales (Q) 27000 6 Required equity investment 2500000 7 Machine B 260 2000000 160 27000 3000000 9 EBIT 10 ROE 11 Difference in ROE 12 Hence, the answer is c.9.33% =(B2-B4) *B5-B3 =(C2-C4)*C5-C3 =B9/B6 =C9/C6 =C10-B10