Question

Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firms fixed costs, F, are $2 million; 50 earth stations are produced and sold each year; profits total $500,000; and the firms assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $4 million to investment and $500,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $10,000 and (2) increase output by 20 units, but (3) the sales price on all units will have to be lowered to $95,000 to permit sales of the additional output. The firm has tax loss carry forwards that cause its tax rate to be zero, its cost of equity is 16%, and it uses no debt.
a. What is the incremental profit? To get a rough idea of the projects profitability, what is the projects expected rate of return for the next year (defined as the incremental profit divided by the investment)? Should the firm make the investment?

b. Would the firms break-even point increase or decrease if it made the change?

c. Would the new situation expose the firm to more or less business risk than the old one?

Answer 1

Answer:

A) incremental profit = $850,000

Next year expected rate of return = 0.094

The firm should make the investment.

B) The firms break even will increase from 40unit to 45.45unit

C) The new situation will expose the firm to less risk, when compared to the old situation.

Explanation:

A) To calculate the incremental profit:

New profit = P2(Q2) - Fc2 - Vc2(Q2).........(1)

New sells price (P2)= $95,000

New unit quantity (Q2) = 50 + 20 = 70

New Fixed cost (Fc2) = $2,000,000 + $500,000 = $2,500,000

New variable cost(Vc2) = ($2,500,000 ÷50) - $10,000 = $40,000

Using equation (1) above

New profit = $95,000(70) - $2,500,000 - $40,000(70)

= $6,650,000 - $2,500,000 - $2,800,000 = $1,350,000

New profit = $1,350,000

The incremental profit;

$1,350,000 - $500,000 = $850,000

Expected rate of return for next year;

$850,000 ÷ ($5,000,000 + $4,000,000)

$850,000 ÷ $9,000,000 = 0.094

Therefore the firm next year rate of return will increase by 0.094.

The firm should make the investment because it has increased it's profit from $500,000 to 850,000. And the increment on profit is expected to grow by next year.

B) The firms break even point;

Break even point = fixed cost ÷ (selling price × variable cost)

Old break even = $2,000,000 ÷ ($100,000 × $50,000) = 40unit

New break even = $2,500,000 ÷ ($95,000 × $40,000) = 45.45unit

Therefore the firms break even will increase if it makes the investment, from 40unit to 45.45unit, which means the profit has actually increased.

C) what will be the risk of the new situation compared to the old situation.

To determine the risk of the new situation and the old situation.

We divide the fixed cost with it's profit. And the decrease in the unit gotten is the decrease in the risk of loss, which means that, as the fixed cost reduces and profit increases, the business will see less risk of loss.

Old situation = $2,000,000 ÷ $500,000 = 5unit

New situation = $2,500,000 ÷ $1,350,000 = 2.85

That means that the new business has less risk that the old business.

Even though this does not determine accurately the risk in the business, because they are some other factors that has to be considered, like the injury the business can cause to life, the security of the business, and many more.