Question

Break-even Point Schweser Satellites Inc. produces satellite earth stations that sell for $95,000 each. The firm's fixed costs, F, are $2.5 million, 50 earth stations are produced and sold each year, profits total $600,000, and the firm's assets (all equity financed) are $4 million. The firm estimates that it can change its production process, adding $4.5 million to assets and $300,000 to fixed operating costs. This change will reduce variable costs per unit by $12,000 and increase output by 18 units. However, the sales price on all units must be lowered to $83,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 13%, and it uses no debt. a. What is the incremental profit? Round your answer to the nearest dollar. 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. X % Should the firm make the investment? b. Would the firm's break-even point increase or decrease if it made the change? The change would increase the break-even point. 4 C. Would the new situation expose the firm to more or less business risk than the old one? 1. It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one. II. The new situation would obviously have more business risk than the old one. III. The new situation would obviously have less business risk than the old one.

Answer 1

a. incremental profit = increase in revenue (increase in output*price per output) + savings in variable cost - increase in Fixed cost

incremental profit = (18*$83,000) + (18*$12,000) - $300,000 = $1,494,000 + $216,000 - $300,000 = $1,410,000

Investment in fixed assets is $4.5 million.

expected rate of return for the next year = incremental profit/investment = $1,410,000/$4,500,000 = 31.33%