We are evaluating a project that costs $903,000, has an 11-year life, and has no

Question

We are evaluating a project that costs $903,000, has an 11-year life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 104,000 units per year. Price per unit is $35, variable cost per unit is $21, and fixed costs are $908,418 per year. The tax rate is 32 percent, and we require a 19 percent return on this project.

(Do not round your intermediate calculations.)

Requirement 1:

(a) Calculate the accounting break-even point.

(b) What is the degree of operating leverage at the accounting break-even point?

Requirement 2:

(a) Calculate the base-case cash flow

(b) Calculate the NPV.

(c) What is the sensitivity of NPV to changes in the sales figure?

(d) What your answer tells you about a 500-unit decrease in projected sales?

Requirement 3:

(a) What is the sensitivity of OCF to changes in the variable cost figure?

(b) What your answer tells you about a $1 decrease in estimated variable costs?

Explanation / Answer

Requirement 1:

a) Breakeven Point = Fixed cost/(selling price-variable cost per unit)

=908418/(35-21)

=64887 units

or $2271045

b) Degree of operating leverage = (sales-v.c)/(sales-vc-fixed cost)

=(3640000-2184000)/(3640000-2184000-908418)

=2.66

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Requirement 2:

a) Base cash flow = (sales-vc-fixed cost)*(1-tax rate)+(depriciation)*(tax rate)

=(3640000-2184000-908418)*(1-32%)+(903000/11)*(32%)

=$398624.85

b) NPV:

Hence, NPV is $885430.35

c) NPV at 100000 units

=$714584.43

Sensitivity = (885430.35-714584.43)/(104000-100000)

=$42.71

d) For 500-unit decrease in projected sales, the NPV would decrease by (500*42.71) = $21355

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Requirement 3:

a) OCF at 100000 units = $360544.85

Sensitivity = (398624.85-360544.85)/(218400-2100000)

=- $0.02 per unit

b) For a $1 decrease in estimated variable costs the OCF would increase by $0.02

Year Cashflows Present Value 0 -903000 -903000 1 398624.85 334978.87 2 398624.85 281494.85 3 398624.85 236550.29 4 398624.85 198781.76 5 398624.85 167043.49 6 398624.85 140372.68 7 398624.85 117960.24 8 398624.85 99126.25 9 398624.85 83299.37 10 398624.85 69999.47 11 398624.85 58823.08 NPV 885430.35

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