You are considering a new product launch. The project will cost $2,200,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 150 units per year; price per unit will be $29,000, variable cost per unit will be $17,500, and fixed costs will be $590,000 per year. The required return on the project is 12 percent, and the relevant tax rate is 34 percent.

You are considering a new product launch. The project will cost $2,200,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 150 units per year; price per unit will be $29,000, variable cost per unit will be $17,500, and fixed costs will be $590,000 per year. The required return on the project is 12 percent, and the relevant tax rate is 34 percent.

  

a.

Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within ±10 percent. What are the upper and lower bounds for these projections? What is the base-case NPV? What are the best-case and worst-case scenarios? (Negative amount should be indicated by a minus sign. Round your NPV answers to 2 decimal places. (e.g., 32.16))

Scenario	Unit Sales	Variable Cost	Fixed Costs	NPV
Base		$	$	$
Best
Worst

b.	Evaluate the sensitivity of your base-case NPV to changes in fixed costs. (Negative amount should be indicated by a minus sign. Round your answer to 3 decimal places. (e.g., 32.161))

ΔNPV/ΔFC

$

  

c.	What is the cash break-even level of output for this project (ignoring taxes)? (Round your answer to 2 decimal places. (e.g., 32.16))

  

Cash break-even

  

d-1	What is the accounting break-even level of output for this project? (Round your answer to 2 decimal places. (e.g., 32.16))

  

Accounting break-even

d-2	What is the degree of operating leverage at the accounting break-even point? (Round your answer to 3 decimal places. (e.g., 32.161))

  

Degree of operating leverage

Explanation:

a.

The base-case, best-case, and worst-case values are shown below. Remember that in the best-case, sales and price increase, while costs decrease. In the worst-case, sales and price decrease, and costs increase.

Using the tax shield approach, the OCF and NPV for the base case estimate is:

  

OCFbase = [($29,000 – 17,500)(150) – $590,000](0.66) + 0.34($2,200,000/4)

OCFbase = $936,100

NPVbase = –$2,200,000 + $936,100(PVIFA12%,4)

NPVbase = $643,262.72

The OCF and NPV for the worst case estimate are:

OCFworst = [($29,000 – 19,250)(135) – $649,000](0.66) + 0.34($2,200,000/4)

OCFworst = $627,385

  

NPVworst = –$2,200,000 + $627,385(PVIFA12%,4)

NPVworst = –$294,412.58

  

And the OCF and NPV for the best case estimate are:

OCFbest = [($29,000 – 15,750)(165) – $531,000](0.66) + 0.34($2,200,000/4)

OCFbest = $1,279,465

  

NPVbest = –$2,200,000 + $1,279,465(PVIFA12%,4)

NPVbest = $1,686,182.18

b.

To calculate the sensitivity of the NPV to changes in fixed costs we choose another level of fixed costs. We will use fixed costs of $600,000. The OCF using this level of fixed costs and the other base case values with the tax shield approach, we get:

OCF = [($29,000 – 17,500)(150) – $600,000](0.66) + 0.34($2,200,000/4)

OCF = $929,500

And the NPV is:

NPV = –$2,200,000 + $929,500(PVIFA12%,4)

NPV = $623,216.22

  

The sensitivity of NPV to changes in fixed costs is:

ΔNPV/ΔFC = ($643,262.72 – 623,216.22)/($590,000 – 600,000)

ΔNPV/ΔFC = –$2.005

For every dollar FC increases, NPV falls by $2.005.

c.

The cash breakeven is:

QC = FC/(P – v)

QC = $590,000/($29,000 – 17,500)

QC = 51.30

d.

The accounting breakeven is:

QA= (FC + D)/(P – v)

QA = [$590,000 + ($2,200,000/4)]/($29,000 – 17,500)

QA = 99.13

At the accounting breakeven, the DOL is:

DOL = 1 + FC/OCF

DOL = 1 + ($590,000/$550,000) = 2.073

For each 1% increase in unit sales, OCF will increase by 2.073%.

Eneliko Company installs home theater systems. The company’s most recent monthly

Exercise 5-9 Compute and Use the Degree of Operating Leverage [LO8]

Eneliko Company installs home theater systems. The company’s most recent monthly contribution format income statement appears below:

		Amount	Percent of Sales
Sales	$	120,000	100%
Variable expenses		84,000	70%
Contribution margin		36,000	30%
Fixed expenses		24,000
Net operating income	$	12,000

Required:
1.	Compute the company’s degree of operating leverage.

Degree of operating leverage

3

2.	Using the degree of operating leverage, estimate the impact on net operating income of a 10% increase in sales. (Input the amount as a positive value. Omit the "%" sign in your response.)

Net operating income increases  by

30  %

3.	Complete the new contribution format income statement for the company assuming a 10% increase in sales. (Input all amounts as positive values except losses which should be indicated by a minus sign. Omit the "$" sign in your response.)

Contribution Income Statement
	Total
Sales	$ 132,000
Variable expenses	92,400
Contribution margin	39,600
Fixed expenses	24,000
Net operating income (loss)	$ 15,600

Pizza Pizazz is a local restaurant. Price and cost information follows:

Pizza Pizazz is a local restaurant. Price and cost information follows:

Price per pizza	$	14.31
Variable cost per pizza
Ingredients		2.18
Direct labor		1.17
Overhead (box, etc.)		.23
Fixed cost per month	$	5,043.10

Requirement 1:

Calculate Pizza Pizazz’s new break-even point under each of the following independent scenarios (Round your intermediate calculations to 2 decimal places and final answer up to next whole number.):

a.	Sales price increases by $1.70 per pizza.

Break-even point

406  units

b.	Fixed costs increase by $510.00 per month.

Break-even point

518  units

c.	Variable costs decrease by $.43 per pizza.

Break-even point

452  units

d.	Sales price decreases by $.30 per pizza.

Break-even point

484  units

Requirement 2:

Assume that Pizza Pizazz sold 495 pizzas last month. Calculate the company’s degree of operating leverage. (Round your intermediate calculations and final answer to 2 decimal places)

Degree of operating leverage

19.80

Requirement 3:

Using the degree of operating leverage, calculate the impact on profit caused by a 15.00 percent increase in sales revenue. (Round your intermediate calculations and final answer to 2 decimal places. Omit the "%" sign in your response.)

Effect on profit

297.00  %

Explanation:

1.
a.	New CM	=	$16.01 – $3.58 = $12.43
	Break-even	=	$5,043.10/$12.43
		=	406.00 units (rounded)

 

b.	New fixed cost	=	$5,553.10
	Break-even	=	$5,553.10/$10.73
		=	518.00 units (rounded)

 

c.	New CM	=	$14.31 – $3.15 = $11.16
	Break-even	=	$5,043.10/$11.16
		=	452.00 units (rounded)

 

d.	New CM	=	$14.01 – $3.58 = $10.43
	Break-even	=	$5,043.10/$10.43
		=	484.00 units (rounded)

 

2.

Degree of operating leverage = Contribution margin/Profit

 

Contribution margin (495.00 x $10.73/unit)	$	5,311.35
– Fixed cost		5,043.10
Profit	$	268.25

 

DOL	=	$5,311.35/$268.25
	=	19.80

3:

Effect on profit	=	Change in sales × Degree of operating leverage
	=	15.00% × 19.80
	=	297.00%

 

Thus, a 15.00% increase in sales will result in a 297.00% increase in profit for Pizza Pizzazz.