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.
- Determine the variable cost per unit
- Determine the new profit if the change is made
- What is the incremental profit?
- What is the projects expected rate of return for the next year (defined as the incremental profit divided by the investment)?
- Should the firm make the investment? Why or why not?
- Would the firm’s break-even point increase or decrease if it made the change?
- Would the new situation expose the firm to more or less business risk than the old one? Show workings