Problem 15-7 Break-even Point Schweser Satellites Inc. produces satellite earth
ID: 2449511 • Letter: P
Question
Problem 15-7
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 $400,000; and the firm's assets (all equity financed) are $4 million. The firm estimates that it can change its production process, adding $4 million to investment and $540,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $11,000 and (2) increase output by 23 units, but (3) the sales price on all units will have to be lowered to $82,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 12%, and it uses no debt.
A) 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?
Yes/No
B) Would the firm's break-even point increase or decrease if it made the change?
Select: Increase or Decrease
C) Would the new situation expose the firm to more or less business risk than the old one?
Select Option Below:
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.
Explanation / Answer
A) Profit in the current situation (All numbers in $) = $ 400,000 Sales 4750000 Variable Costs 1850000 Variable Cost per unit is 1,850,000/50 = $ 37,000 per satellite unit Gross Profit 2900000 Fixed Costs 2500000 Net Profit 400000 In case of the change in production process Units Price Value $ Sales 73 82000 5986000 Variable Costs 73 26000 1898000 Gross Profit 4088000 Fixed Costs 3040000 Net Profit 1048000 The incremental net profit would be $ 1,048,000 - $ 400,000 = 648000 $ Project's expected rate of return for the next year would be 16.20% (Incremental Profit of 648,000 divided by the additional investment of $ 4,000,000) A1) Since the expected rate of return is more than the cost of capital 12%, Schweser Satellites Inc. should ideally make the investment. B) Breakeven point in original scenario = 4350000 Breakeven point in new scenario = 4938000 Hence, in case the change in production process is implemented, the breakeven point of Schweser would increase by $ 588,000. C) In the absence of complete information pertaining to other factors, it is impossible to state enquivocally if the change in production process would have more or less business risk than the old one.