You are considering investing in a company that cultivates abalone for sale to l

Question

You are considering investing in a company that cultivates abalone for sale to local restaurants. Use the following information: Sales price per abalone = $34.60 Variable costs per abalone = $5.70 Fixed costs per year = $371,000 Depreciation per year = $116,000 Tax rate = 34% The discount rate for the company is 13 percent, the initial investment in equipment is $696,000, and the project’s economic life is six years. Assume the equipment is depreciated on a straight-line basis over the project’s life.

What is the accounting break-even level for the project?

What is the financial break-even level for the project?

Explanation / Answer

Accounting Break even level = Fixed cost / Profit Volume ratio

Fixed costs = 487000 ( 371000 +116000 Note 1 )

Profit Volume ratio = Sales - Variable Costs / Sales * 100

   = 34.60 - 5.70 / 34.60 *100

= 83.526 %

Accounting Break even level = 487000 / 83.526 % = $583052

Note 1 :- Depreciation ($116000) is also considered as part of fixed cost for calculating Accounting Break even level. Alternatively, it can be ignored also. But in my opining taking depreciation as a part of fixed cost for arriving at Accounting Break even level will give more viable & acceptable answer.

Financial Break even level =Financial break even point means the level of Earning before interest & Taxes (EBIT) where Earnings per share (EPS) is 0. In other words, the Financial break even point is the minimum level of EBIT needed to satisfy all fixed financial charges i.e. Interest and Preference dividend.

Assuming the Capital structure of company consisting only equity, as no information regarding Debt & Preference is given in question, therefore, Financial break even point is taken as Zero.

Financial break even point in various kinds of Capital structure of company calculated as below:-

Equity & Debenture

Only Equity Zero Equity & Preference shares Preference Dividend / (1 - Tax rate)

Equity & Debenture

Interest Equity, Debenture & Preference shares Interest + Preference Dividend / (1 - Tax rate)

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