Gamut Satellite Inc. produces satellite earth stations that sell for $150,000 each. The firm’s fixed costs, F, are $1.5 million, 20 earth stations are produced and sold each year, profits total $400,000, and the firm’s assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $10 million to assets and $500,000 to fixed operating costs. This change will reduce variable costs per unit by $5,000 and increase output by 30 units. However, the sales price on all units must be lowered to $140,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 18%, and it uses no debt.
a. Determine the variable cost per unit
b. Determine the new profit if the change is made
c. What is the incremental profit?
d. What is the projects expected rate of return for the next year (defined as the incremental profit divided by the investment)?
e. Should the firm make the investment? Why or why not?
f. Would the firm’s break-even point increase or decrease if it made the change?
g. Would the new situation expose the firm to more or less business risk than the old one? Show workings
Sample Solution
