Question

Schweser Satellites Inc. produces satellite earth stations that sell for $95,000 each. The firm's fixed costs, F, are $1.5 million, 50 earth stations are produced and sold each year, profits total $600,000, and the firm's assets (all equity financed) are $6 million. The firm estimates that it can change its production process, adding $3 million to assets and $570,000 to fixed operating costs. This change will reduce variable costs per unit by $10,000 and increase output by 25 units. However, the sales price on all units must be lowered to $85,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 14%, 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. % Should the firm make the investment?

Answer 1

1) Incremental profit

First we need to determine the current variable cost per unit -

Profit = Sales - Variable Costs - Fixed costs

or, $600,000 = (50 x $95000) - Variable costs - $1,500,000

or, Variable costs = $2,650,000

Variable cost per unit = $2,650,000 / 50 = $53,000

This will reduce by $10000 to $43000 per unit.

Sale of new units (25 x $85000)	$2,125,000
Less: Reduced sales on old units [ 50 x ($95000 - $85000) ]	$500,000
Less: Variable cost on new units (25 x $43000)	$1,075,000
Add: Savings in variable cost on old units (50 x $10,000)	$500,000
Less: Incremental fixed costs	$570,000
Incremental profit	$480,000

b) Expected rate of return = (Incremental Profit / investment) x 100 = ($480,000 / $3,000,000) x 100 = 16.00%

c) Yes, the firm should make the investment as the expected rate of return of 16% is more than the cost of equity of 14%.