Question

Brutech Corporation is considering whether or not to launch its new product, a kioskfor checking in medical patients at doctor’s offices. Marketing research is confidentthe kioskwill sell 1,300units per year, but the finance department is also evaluating the risks that unit sales and other key forecast variables might pose if the initial data differs from reality.

In the Base Case, the selling price on the 1,300 units will be $2,100 per kiosk. Variable costsper unitwill be $1,300, and fixed costs will be $200,000 per year. The company pays a tax rate of 34%. The total investment needed to undertake the projectis $2,500,000. This amount (I) will be depreciated straight-line to zero over the five-year life of the equipment. The salvage value is zero, and there are no working capital consequences. Brutechhas a 25percent required return on new projects.

Theproject has a zero NPV when the present value of the operating cash flows equals the $2,500,000 investment. Because the cash flow is the same each year, we can solve for the unknown amount by viewing it as an ordinary annuity. Sincethe formula for calculating PVIFAr,Nis [1-(1+r)-N]/r, the PVIFA25%,5= [1-(1.25)-5]/0.25= (1-.326780) / 0.25 = .672320 / 0.25 = 2.6893TheOCF* can /be determined as follows:OCF*= $2,500,000/2.6893

                            Lower Bound                     Upper Bound

Unit Sales                  1,200                                 1,400

Sales price per unit       $1,800                          $2,400

Variable cost per unit     $1,100                        $1,500

Fixed Costs                 $150,000                      $250,000

1-Ignoretaxes, What is the OCF at 1000units?

2-Ignoretaxes, What is the Degree of Operating Leverage (DOL) at 1300 units?

Answer 1

Depreciation = 2500000/5 = 500000

Cashflows = ((Sales Price-Variable Cost)*Unit Sales - Fixed Cost)*(1-Tax Rate)+Depreciation

For OCF = 1000

Variable cost and fixed cost will be equal to the lower bound one

Cashflows = ((1800-1100)*1000 - 150000)*(1-34%) + 500000 = 863000

OCF = 863000

Similarly for 1300 units

Cashflows = ((2100-1300)*1300 - 200000)*(1-34%) + 500000 = 1054400

For 1400 units,

Cashflows = ((2400-1500)*1400 - 250000)*(1-34%) + 500000 = 1166600

Change in cashflows = (1166600-1054400)/1054400 =10.64%

Change in sales = (1400-1300)/1300 = 7.69%

Degree of Operating Leverage (DOL) = change in cashflows/change in sales = 10.64%/7.69% = 1.383