Schweser Satellites Inc. produces satellite earth stations that sell for $95,000

Question

Schweser Satellites Inc. produces satellite earth stations that sell for $95,000 each. The firm's fixed costs, F, are $2.5 million, 50 earth stations are produced and sold each year, profits total $400,000; and the firm's assets (all equity financed) are $6 million. The firm estimates that it can change its production process, adding $4 million to investment and $520,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $9,000 and (2) increase output by 25 units, but (3) the sales price on all units will have to be lowered to $83,000 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?

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.

Explanation / Answer

The project's expected rate of return for next year:

Project's expected rate of return = Incremental profit / Net investment in the project = $ 705,000 / $ 4,000,000 = 17.63% or 0.1763

This year Next year $ $ Sales 4,750,000 6,225,000 Variable cost 1,850,000 2,100,000 Contribution margin 2,900,000 4,125,000 Fixed costs 2,500,000 3,020,000 Net operating income 400,000 1,105,000 Incremental profit 705,000

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