Question

Schweser Satellites Inc. produces satellite earth stations that sell for $115,000 each. The firm's fixed costs, F, are $3 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 $3 million to assets and $500,000 to fixed operating costs. This change will reduce variable costs per unit by $12,000 and increase output by 15 units. However, the sales price on all units must be lowered to $110,000 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.
What is the incremental profit? Enter your answer in dollars. For example, an answer of $4 million should be entered as 4,000,000, not 4. 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.
%

Should the firm make the investment?


-Select-

Would the firm's break-even point increase or decrease if it made the change?
The change would
-Select-
the break-even point.

Would the new situation expose the firm to more or less business risk than the old one?
I. The new situation would obviously have more business risk than the old one.
II. The new situation would obviously have less business risk than the old one.
III. It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one.


-Select-

Answer 1

The incremental profit is $175,000 and the new situation would obviously have less business risk than the old one.

Incremental profit

First step

Profit $600,000

Add Fixed cost $3,000,000

Contribution $3,600,000

Variable Cost=Total Sales−Contribution

Variable Cost=$115,000×50-$3,600,000

Variable Cost=$2,150,000

Second step

Profit at revised cost

Sales $8,625,000

(75x $115,000)

Less: Variable cost $4,350,000

[75×($3,000,000+$500,000/50-$12,000)]

Contribution $4,275,000

Less Fixed cost $3,500,000

($3,000,000+$500,000)

Profit $775,000

Incremental profit=Profit at revised cost-Existing profit

Incremental profit=$775,000-$600,000

Incremental profit=$175,000

Expected rate of return=Incremental profit/Investment

Expected rate of return=$175,000/$4,000,000×100

Expected rate of return=$4.375%

2. Break-even point

Existing

Break-even point=Fixed cost/Contribution

Break-even point=$3,000,000/[($115,000-($3,000,000+$500,000/50)]

Break-even point=$3,000,000/[($115,000-$70,000)

Break-even point= 66.67

Revised

Break-even point=Fixed cost/Contribution

Break-even point=$3,500,000/[($110,000-($3,000,000/50)]

Break-even point=$3,000,000/[($110,000-$60,000)

Break-even point=60

II. The new situation would obviously have less business risk than the old one.

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