Problem 11-25 Break-Even and Taxes [LO3] Wettway Sailboat Corporation is conside
ID: 2727435 • Letter: P
Question
Problem 11-25 Break-Even and Taxes [LO3] Wettway Sailboat Corporation is considering whether to launch its new Margo-class sailboat. The selling price will be $32,000 per boat. The variable costs will be about half that, or $16,000 per boat, and fixed costs will be $500,000 per year. The Base Case: The total investment needed to undertake the project is $2,600,000. This amount will be depreciated straight-line to zero over the five-year life of the equipment. The salvage value is zero, and there are no working capital consequences. Wettway has a 12 percent required return on new projects.
Use the above expression to find cash, accounting and financial break-even points for Wettway Sailboat. Assume a tax rate of 38 percent.
Explanation / Answer
Part A)
The cash break-event point is calculated with the use of following formula:
Cash Break-Even Point = Fixed Cost/(Selling Price Per Boat - Variable Cost Per Boat)
________
Using the values provided in the question, we get,
Cash Break-Even Point = 500,000/(32,000 - 16,000) = 31.25 boats or 31 boats
________
Part B)
The accounting break-event point is calculated with the use of following formula:
Accounting Break-Even Point = (Fixed Cost + Depreciation)/(Selling Price Per Boat - Variable Cost Per Boat)
________
Using the values provided in the question, we get,
Annual Depreciation = (Cost - Salvage Value)/Estimated Life = (2,600,000 - 0)/5 = 520,000
Now, we can calculate the accounting break-even point as follows:
Accounting Break-Even Point = (500,000 + 520,000)/(32,000 - 16,000) = 63.75 boats or 64 boats
________
Part C)
The financial break-event point is calculated with the use of following formula:
Financial Break Even Point = (Fixed Cost + (Operating Cash Flow - Tax*Depreciation)/(1-Tax))/(Selling Price Per Boat - Variable Cost Per Boat)
We will have to determine the operating cash flow with the use of investment cost and required rate of return as follows:
2,600,000 = OCF*PVIFA(12%,5 Years) [at this level NPV is 0]
Solving for OCF, we get,
OCF = 2,600,000/3.6048 = $721,260.54
Now, we can calculate the financial break-even point as follows:
Financial Breal-Even Point = [500,000 + ((721,260.54 - 520,000*38%)/(1-38%))]/(32,000 - 16,000) = 84 boats