you are evaluating a project that costs $724,000 has an 8 yr life, and has no sa
ID: 2668500 • Letter: Y
Question
you are evaluating a project that costs $724,000 has an 8 yr life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 90,000 units per year. Price per unit is $43, variable cost per unit is $29, and fixed costs are $780,000 a year. The tax rate is 35%, and we require a 15% return on this project.
c) What is the sensitivity of OCF to changes in the variable
cost figure? Explain what your answer tells you about a $1 decrease in
estimated variable costs.
Explanation / Answer
Sensitivity of OCF to changes in the variable cost: In order to measure the sensitivity of Ooerating cash flows (OCF), we have to calculate the ocf for both cases as follows; First we have to calculate the profit for actual variable cost; OCF at actual variable cost: Profit = Sales - (variable cost + fixed cost) = (90,000 x $43) - [(29 x 90,000) + 780,000] = $3,870,000 - (2,610,000 + 780,000) = $480,000 Depreciation = cost of the asset / life of the asset = $724,000 / 8 = 90,500 So earnings before interest and taxes and depreciation (EBITD) = $480,000 Less: depreciation = 90,500 So Earnings afeter depreciation before interest and taxes = 389,500 less: interest = 0 Earnings before taxes and after interest (EBT) = 389,500 less: taxes (35%) = 136,325 Earnings after taxes = $253,175 So operating cash flows (OCF) = $253,175 OCF at decreased variable cost: Profit = Sales - (variable cost + fixed cost) = (90,000 x $43) - [(28 x 90,000) + 780,000] = $3,870,000 - (2,520,000 + 780,000) = $570,000 Depreciation = cost of the asset / life of the asset = $724,000 / 8 = 90,500 So, earnings before interest and taxes and depreciation (EBITD) = $570,000 Less: depreciation = 90,500 So Earnings afeter depreciation before interest and taxes = 479,500 less: interest = 0 Earnings before taxes and after interest (EBT) = 479,500 less: taxes (35%) = 167,825 Earnings after taxes = $311,675 So operating cash flows (OCF) = $311,675 Sensitivity analysis: OCF at actual variable cost = $253,175 OCF at decreased variable cost = $311,675 So increase in OCF for decrease in $1 variable cost per unit = $58,500 As the fixed cost remains constant the decrease in variable cost leads to increase in OCF. OCF at decreased variable cost: Profit = Sales - (variable cost + fixed cost) = (90,000 x $43) - [(28 x 90,000) + 780,000] = $3,870,000 - (2,520,000 + 780,000) = $570,000 Depreciation = cost of the asset / life of the asset = $724,000 / 8 = 90,500 So, earnings before interest and taxes and depreciation (EBITD) = $570,000 Less: depreciation = 90,500 So Earnings afeter depreciation before interest and taxes = 479,500 less: interest = 0 Earnings before taxes and after interest (EBT) = 479,500 less: taxes (35%) = 167,825 Earnings after taxes = $311,675 So operating cash flows (OCF) = $311,675 Sensitivity analysis: OCF at actual variable cost = $253,175 OCF at decreased variable cost = $311,675 So increase in OCF for decrease in $1 variable cost per unit = $58,500 As the fixed cost remains constant the decrease in variable cost leads to increase in OCF. OCF at actual variable cost = $253,175 OCF at decreased variable cost = $311,675 So increase in OCF for decrease in $1 variable cost per unit = $58,500 As the fixed cost remains constant the decrease in variable cost leads to increase in OCF.Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.