A3Q7 For the following questions, assume no taxes and straight-line depreciation
ID: 2807476 • Letter: A
Question
A3Q7
For the following questions, assume no taxes and straight-line depreciation.
a. What is the cash break-even quantity, and how is it calculated? Use both words and an equation in your explanation. Include a discussion of payback period, NPV, and IRR at the cash break-even sales level.
b. What is the accounting break-even quantity, and how is it calculated? Use both words and an equation in your explanation. Include a discussion of payback period, NPV, and IRR at the accounting break-even sales level.
c. What is the financial break-even quantity, and how is it calculated? Explain using both words and an equation. Make sure that you discuss the two steps involved in finding the financial break-even point. Also, include a discussion of discounted payback period, NPV, and IRR at the financial break-even sales level.
Explanation / Answer
Answer a. Cash Break Even Point is the quantity of sales required to cover all of the operating expenses. It is the point which requires the volume of sales just enough to cover all of its cost. At this quantity the firm neither earns profit nor losses.
A project may break even on accounting basis but still may have a positive cash flow, but at some point in time the cash flow goes negative, at this time only we have to supply additional cash flow to support the project.
Break even quantity could be calculated by the following equation:
Break Even Quantity = Fixed Cost/ (Selling Price per unit- Variable Cost per unit)
At Cash Break Even Point NPV is Zero, where the revenue just matches with the cost.
Payback period is the time period required to reach a volume of sale, where it reaches the break even quanitity.
Similarly, At break even point, the IRR is just equal to the cost of funds.
b. Accounting Break-Even Quantity: Accounting break even point means the point where the project net income becomes zero. It is one of the most important tool for project Analysis. It is basically calculated by Adding Fixed cost and Depreciation and dividing by the sales price per unit less variable cost per unit.
Accounting Break even Quantity = (Fixed Cost + Depreciation)/ (Sales - Variable Cost)
Accounting Break Even Quantity and Payback Period: As and when the project goes for accounting break even point, the total of cash flows of that period would equal to the depreciation arising from the project.
NPV and Accounting Break Even : In order to calculate the cash flows for the project, the cash flows is calculated by adding the EBIT with the depreciation, and then only the NPV is calculated. The accounting breakeven is arrived at a point where NPV is negative and has zero return.
A project arrives at accounting break even point where it doesnt payback anything and hence it has zero return, here IRR will be -100 percent.
c. Financial Break-even Quantity: Financial Break even point is the minimum EBIT which should be just enough to cover all of its fixed commitments like preference dividends, interests and taxes.
Financial Break Even Quantity = Fixed Operating Expenses/ Gross Profit Margin
It is a point where the project NPV is zero.
IRR is just enough to cover the cost of funds like interest.
Payback Period: The payback period is the period where the project generates just enough to cover its operating costs.