PART FOUR Capital Budgeting

3. Marginal Cash Flows A co-worker claims that looking at all this marginal this and incremental that is just a bunch of nonsense, and states: "Listen, if our average revenue doesn't exceed our average cost, then we will have a negative cash flow, and we will go broke!" How do you respond?

4. Operating Leverage At one time at least, many Japanese companies had a "no layoff' policy (for that matter, so did IBM). What are the implications of such a policy for the degree of operating leverage a company faces?

5. Operating Leverage Airlines offer an example of an industry in which the degree of operating leverage is fairly high. Why?

6. Break-Even As a shareholder of a firm that is contemplating a new project, would you be more concerned with the accounting break-even point, the cash break-even point, or the financial break-even point? Why?

7. Break-Even Assume a firm is considering a new project that requires an initial investment and has equal sales and costs over its life. Will the project reach the accounting, cash, or financial break-even point first? Which will it reach next? Last? Will this ordering always apply?

8. Capital Rationing How are soft rationing and hard rationing different? What are the implications if a firm is experiencing soft rationing? Hard rationing?

9. Capital Rationing Going all the way back to Chapter 1, recall that we saw that partnerships and proprietorships can face difficulties when it comes to raising capital. In the context of this chapter, the implication is that small businesses will generally face what problem?

Questions and Problems


(Questions 1-15)

Calculating Costs and Break-Even Bob's Bikes Inc. (BBI) manufactures biotech sunglasses. The variable materials cost is $.74 per unit and the variable labor cost is $2.61 per unit.

a. What is the variable cost per unit?

b. Suppose BBI incurs fixed costs of $610,000 during a year in which total production is 300,000 units. What are the total costs for the year?

c. If the selling price is $7.00 per unit, does BBI break even on a cash basis? If depreciation is $150,000 per year, what is the accounting break-even point?

Computing Average Cost Everest Everwear Corporation can manufacture mountain climbing shoes for $10.94 per pair in variable raw material costs and $32 per pair in variable labor expense. The shoes sell for $95 per pair. Last year, production was 140,000 pairs. Fixed costs were $800,000. What were total production costs? What is the marginal cost per pair? What is the average cost? If the company is considering a one-time order for an extra 10,000 pairs, what is the minimum acceptable total revenue from the order? Explain. Scenario Analysis Covington Transmissions, Inc., has the following estimates for its new gear assembly project: price = $1,850 per unit; variable costs = $160 per unit; fixed costs = $7 million; quantity = 90,000 units. Suppose the company believes all of its estimates are accurate only to within ±15 percent. What values should the company use for the four variables given here when it performs its best-case scenario analysis? What about the worst-case scenario? Sensitivity Analysis For the company in the previous problem, suppose management is most concerned about the impact of its price estimate on the project's profitability. How could you address this concern for Covington Transmissions? Describe how you would calculate your answer. What values would you use for the other forecast variables?

Sensitivity Analysis and Break-Even We are evaluating a project that costs $924,000, has a six-year life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 130,000 units per year. Price per unit is $34.00, variable cost per unit is $19, and fixed costs are $800,000 per year. The tax rate is 35 percent, and we require a 15 percent return on this project.

a. Calculate the accounting break-even point. What is the degree of operating leverage at the accounting break-even point?

b. Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to changes in the sales figure? Explain what your answer tells you about a 500-unit decrease in projected sales.

c. What is the sensitivity of OCF to changes in the variable cost figure? Explain what your answer tells you about a $1 decrease in estimated variable costs.

Scenario Analysis In the previous problem, suppose the projections given for price, quantity, variable costs, and fixed costs are all accurate to within ±10 percent. Calculate the best-case and worst-case NPV figures. Calculating Break-Even In each of the following cases, calculate the accounting break-even and the cash break-even points. Ignore any tax effects in calculating the cash break-even.


(continued )

Unit Price

Unit Variable Cost

Fixed Costs






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