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# Finance Questions and Variable Cost of Producing Bikes

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[Problem 1] A recently retired corporate executive, Mr. CEO, plans to establish the Big Bike Bicycle Company and manufacture the bikes. He estimates the fixed costs of operations to be \$500,000 annually. The variable cost of producing the bikes is forecasted to be \$150 per unit.

(a) If the bikes are priced at \$200, how many must be sold to break even?

(b) What is the cash break-even point if \$200,000 depreciation expense is included in fixed costs?

(c) If Mr. CEO seeks to earn \$100,000 in profits, how many bikes must be sold?

(d) How much would Big Bike's DOL (Degree of Operating Leverage) be:

(1) At a sales level of \$22,000 units
(2) At 30,000 units?

(e) What would be the percentage loss of operating profit if Big Bike's sales tumbled to 24,000 from a high of 40,000 units?

(1) Answer by computing the operating profit at each level of sales.
(2) Answer by using the DOL method.

[Problem 2] You're a Corporate Loan officer for Mannington National Bank evaluating Aluminum Industries, Inc., which has requested a \$3 million loan. As the loan officer you are required to assess the firm's financial leverage and risk.

Use the above Balance Sheet, Income Statement, and Industry Averages, prepare a table calculating the following ratios for Aluminum: Debt, Debt-Equity, and Times Interest Earned Ratios. Compare these ratios to the Industry Averages.
Based on your analysis of the calculations and comparisons, make a statement regarding the action you will choose regarding Aluminum's loan request.

[Problem 3] Eastern Chemical Company is considering two mutually exclusive investments. The projects' expected net cash flows are as follows:

Expected Net Cash Flows
Year Project A Project B
0 \$(45,000) \$(50,000)
1 (20,000) 15,000
2 11,000 15,000
3 20,000 15,000
4 30,000 15,000
5 45,000 15,000

a. Calculate the NPV for each project the RRR is 13%
b. Assuming the Cost of Capital is 13 percent, calculate the IRR for each project.
c. At 13% Cost of Capital, which project should Eastern choose?
d. At 9% Cost of Capital, which project should Eastern choose?
e. At 15% Cost of Capital, Which project should Eastern choose?
f. At what rate doe the NPV profiles of the two projects cross?

[Problem 4] The Hall Company expects to receive the following cash flows in the next 10 years. Calculate the Present Value of this stream of cash flows if the discount rate is 10%.

Year Cash flow
1 \$ 2,500,000
2 \$ 2,500,000
3 \$ 2,500,000
4 \$ 4,000,000
5 \$ 5,150,000
6 \$ 1,225,000
7 \$ 5,000,000
8 \$ 5,000,000
9 \$ 5,000,000
10 \$ 5,000,000

#### Solution Summary

The solution explains various questions in finance. The variable costs of producing bikes for a CEO are determined.

\$2.19

## Present Value Analysis - James Hardy

Hi,

Thank you so much.

James Hardy recently rejected a \$14,000,000, five-year contract with the Vancouver Seals.
The contract offer called for an immediate signing bonus of \$4,000,000 and annual
payments of \$2,000,000. To sweeten the deal, the president of player personnel for the
Seals has now offered a \$16,000,000, five-year contract. This contract calls for annual
increases and a balloon payment at the end of five years.

Year 1 \$2,000,000
Year 2 2,100,000
Year 3 2,200,000
Year 4 2,300,000
YearS 2,400,000
Year 5 balloon pymt 5,000,000
Total \$16,000,000
Quality Shoe Company is considering investing in one of two machines that attach heels to shoes.
Machine A costs \$60,000 and is expected to save the company \$18,000 per year for six
years. Machine B costs \$85,000 and is expected to save the company \$23,000 per year
for six years. Determine the net present value for each machine and decide which machine
should be purchased if the required rate of return is 10 percent. Ignore taxes.
National Cruise Line, Inc. is considering the acquisition of a new ship that will cost \$180,325,005. In this regard, the president of the company asked the CFO to analyze cash flows associated with operating the ship under two alternative itineraries: Itinerary 1, Caribbean Winter/Alaska Summer and Itinerary 2, Caribbean Winter/Eastern Canada Summer. The CFO estimated the following cash flows, which are expected to apply to each of the next 15 years: \$180,325,005
In this regard, the president of the company asked the CFO to analyze cash flows associated with operating the
ship under two alternative itineraries: Itinerary 1, Caribbean Winter/Alaska Summer and Itinerary 2, Caribbean
Winter/Eastern Canada Summer. The CFO estimated the following cash flows, which are expected to apply to
each of the next 15 years:
Net revenue \$119,789,010 \$103,904,336
Less:
Direct program expenses (24,091,051) (22,812,140)
Indirect program expenses (19,437,162) (19,437,162)
Non-operating expenses (20,186,695) (20,186,401)
Cash flow per year \$68,095,769 \$53,490,300

Associated Penguin Productions is evaluating a film project. The president of Associated
Penguin estimates that the film will Gost \$18,000,000 to produce. In its first year, the film
is expected to generate \$14,500,000 in net revenue, after which the film will be released to
video. Video is expected to generate \$7,000,000 in net revenue in its first year, \$1,500,000
in its second year, and \$500,000 in its third year. For tax purposes, amortization of the
cost of the film will be \$14,000,000 in year 1 and \$4,000,000 in year 2. The company's
tax rate is 40 percent, and the company requires a 12 percent rate of return on its films.
The Boston Culinary Institute is evaluating a classroom remodeling project. The cost of the remodel
will be \$200,000 and will be depreciated over 5 years using the straight-line
method. The remodeled room will accommodate 5 extra students per year. Each
student pays annual tuition of \$15,000 The before-tax incremental cost of a student (e.g., the cost
of food prepared and consumed by a student) is \$1,360 per year. The company's tax rate
is 40% and the company requires a 12% rate of return on the remodeling
project.

Required:
Assuming a 5 -year time horizon, what is the internal rate of return of the remodeling
project? Should the company invest in the remodel?
Van Doren Corporation is considering producing a new product, Autodial. Marketing data
indicate that the company will be able to sell 35,000 units per year at \$35. The product
will be produced in a section of an existing factory that is cun-ently not in use.

To produce Autodial, Van Doren must buy a machine that costs \$410,000. The
machine has an expected life of five years and will have an ending residual value of
\$12,000. Van Doren will depreciate the machine over five years using the straight-line
method for both tax and financial reporting purposes.

In addition to the cost of the machine, the company will incur incremental manufacturing
costs of \$350,000 for component parts, \$400,000 for direct labor, and
\$185,000 of miscellaneous costs. Also, the company plans to spend \$135,000 annually
for advertising Autodial. Van Doren has a tax rate of 40 percent, and the company's required
rate of return is 12 percent.
The results of operations for the Preston Manufacturing Company for the fourth
quarter of 2007 were as follows (in thousands):

Sales \$500,000
Less variable cost of sales 300,000
Contribution margin 200,000
Less fixed production costs \$100,000
Less fixed selling and administrative expenses 50,000 150,000
Income before taxes 50,000
Less taxes on income 20,000
Net income \$30,000

Note: Preston Manufacturing uses the variable costing method. Thus, only variable
production costs are included in inventory and cost of goods sold. Fixed production
costs are charged to expense in the. period incurred.

The company's balance sheet as of the end of the fourth quarter of 2007 was as
Bowser Products operates a small plant in New Mexico that produces dog food in
batches of 1,000 pounds. The product sells for \$3 per pound. Standard costs for 2009 are:

Standard direct labor cost = \$15 per hour
Standard direct labor hours per batch = 8 hours
Standard cost of material A = \$0.20 per pound
Standard pounds of material Aper batch = 800 pounds·
Standard cost of material B = \$0.40 per pound
Standard pounds of material B per batch = 200 pounds
Fixed overhead cost per batch = \$400

At the start of 2009, the company estimated monthly production and sales of 40
batches. The company estimated that all overhead costs were fixed and amounted to
\$16,000 per month. During the month of June, 2009 (typically a somewhat slow
month) 30 batches were produced (not an unusual level of production for this month).
The following costs were incurred:

Direct labor costs were \$4,800 for 300 hours
24,500 pounds of material Acosting \$4,655 were purchased and used
5,900 pounds of material B costing \$2,419 were purchased and used
Fixed overhead of \$15,500 was incurred

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