Satellites Inc. produces satellite earth stations that sell for $100,000 each. T

Question

Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firm’s fixed costs, F, are $2 million; 50 earth stations are produced and sold each year; profits total $500,000; and, the firm’s 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 render its tax rate 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 project’s profitability, what is the project’s expected rate of return for the next year (defined as the incremental profit dividend by the investment)? Should the firm make the investment?

b. Would the firm’s break-even point increase or decrease if it made the change? Explain.

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

Explanation / Answer

Answer:

a)

Profitability =  incremental profit dividend by the investment = $850,000/$4,000,000 = 21.25%

The firm shold make investment owing to the high positive return higher than cost of equity.

b) The change in break even point increases as below:

c)

The new situation will expose the firm to more business risk then earlier.

Existing New Per unit Total Per unit Total Incremental profit No of units 50 70 Selling price 100000 5000000 95000 6650000 Less: Variable Cost (Balancing fig.) 50000 2500000 40000 2800000 Less: Fixed cost 2000000 2500000 Profit 500000 1350000 850000

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