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Practice Problem

1. Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firm's fixed costs, F, are $2 million; 50 earth stations are produced and sold each year; profits total $500,000; and the firm's assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $4 million to investment and $500,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $10,000 and (2) increase output by 20 units, but (3) the sales price on all units will have to be lowered to $95,000, to permit sales of the additional output. The firm has tax loss carry-forwards that cause its tax rate to be zero, its cost of equity is 15 percent, and it uses not debt.

a. Should the firm make the change?
b. Would the firm's operating leverage increase or decrease if it made the change? What about its breakeven point?
c. Would the new situation expose the firm to more or less business risk than the old one?

Show all work and fully explain your answer.

Solution Preview

a. Should the firm make the change?
<br>We should compare the company's profit before and after the change.
<br>Before the change, the total revenue is TR=P*Y=100,000*50=5,000,000
<br>Variable cost (VC) = TR-Profit-F=5,000,000-500,000-2,000,000=2500,000$
<br>Average Variable cost is then AVC=VC/y=2500,000/50=50,000
<br>After the change, the total revenue will be TR'=P' * Y' =95000*(50+20)= $6,650,000
<br>The fixed costs will be F'= 2000000+500000=2500,000
<br>Average variable cost is reduced by $10,000 now:
<br>AVC'=AVC-10,000=50,000-10,000 = 40,000
<br>So the total variable cost is ...