Chapter 12

Evaluating Project Economics and Capital Rationing

Learning Objectives

1. Explain and be able to demonstrate how variable costs and fixed costs affect the
volatility of pretax operating cash flows and accounting operating profits.
2. Calculate and distinguish between the degree of pretax cash flow operating leverage
and the degree of accounting operating leverage.
3. Define and calculate the pretax operating cash flow and accounting operating profit
break-even points and the crossover levels of unit sales for a project.
4. Define sensitivity analysis, scenario analysis, and simulation analysis, and describe how
they are used to evaluate the risks associated with a project.
5. Explain how the profitability index can be used to rank projects when a firm faces
capital rationing, and describe limitations that apply to the profitability index.

I.

Chapter Outline

12.1

Variable Costs, Fixed Costs, and Project Risk

Variable costs (VC) are costs that vary directly with the number of units sold.

Fixed costs (FC), in contrast, do not vary with unit sales in the short run.

The cash flows and accounting profits for a project are sensitive to the proportion of
its costs that are variable and the proportion that are fixed.
A project with a higher proportion of fixed costs will have cash flows and
accounting profits that are more sensitive to changes in revenues than an
otherwise identical project with a lower proportion of fixed costs.

EBITDA is often called pretax operating cash flow because it equals the
incremental pretax cash operating profits from a project.
EBITDA = Revenue VC FC
Op Ex = VC + FC

By comparing the sensitivity of EBITDA to changes in revenue between two project

alternatives, it may help to better understand the risks and returns for each of the
alternatives.
Distinguishing between fixed and variable costs will then enable us to calculate
the sensitivity of EBITDA to changes in revenue.

The greater the proportion that total costs are fixed will make it more
difficult to adjust costs when revenue changes.

EBIT is more sensitive to changes in revenue than EBITDA because the EBITDA
does not include depreciation and amortization.

Depreciation and amortization acts just like a fixed cost because it is based
on the amount that was invested in the project.

12.2

Calculating Operating Leverage

Operating leverage is a measure of the sensitivity of EBITDA or EBIT to changes

in revenue.

Two measures of operating leverage are often used by analysts: the degree of
pretax cash flow operating leverage and the degree of accounting operating
leverage.

A.

Degree of Pretax Cash Flow Operating Leverage

The degree of pretax cash flow operating leverage (Cash Flow DOL)
provides us with a measure of how sensitive pretax operating cash flows are to
changes in revenue.

Fixed Costs
FC
= 1+
.
Pretax Operating Cash Flows
EBITDA

Cash Flow DOL changes with the level of revenue; the sensitivity of

Cash Flow DOL = 1 +

operating cash flows is not the same for all levels of revenue.
B.

Degree of Accounting Operating Leverage

The degree of accounting operating leverage (Accounting DOL) is a

measure of how sensitive accounting operating profits, EBIT, are to changes
in revenue.

Accounting DOL = 1 +

Fixed Charges
Accounting Operating Profits

FC + D&A
EBITDA - D&A

=1+

FC + D&A
.
EBIT

o D&A is treated as a fixed cost and is added to FC to obtain the total of

the cash and noncash fixed costs that would be reflected in the income
statement if the project were adopted.

12.3

Break-Even Analysis
Break-even analysis tells us how many units must be sold in order for a project to break
even on a cash flow or accounting profit basis.

A.

Cash Flow Break-Even

The pretax operating cash flow (EBITDA) break-even point is calculated as follows:
EBITDA Break-Even =

FC
Price - Unit VC

Simply divide the fixed costs, FC, by the per-unit contribution (Price
Unit VC).

o The cross-over level of unit sales (CO) is calculated as follows:

CO EBITDA =

FCAlternative1 - FC Alternative 2
Unit Contribution Alternative1 - Unit Contribution Alternative 2

where Unit contribution stands for the per-unit contribution.

When using the above formula, make sure that the smaller value of FC is
in the second term in the numerator since putting the smaller number first
will usually give you a negative answer.

B.

Accounting Break-Even

The accounting operating profit (EBIT) break-even point is calculated as:

EBIT Break-Even =

FC + D&A
.
Price - Unit VC

o When we calculate the accounting operating profit break-even point, we

are calculating how many units must be sold to avoid an accounting
operating loss.

12.4

Risk Analysis
A.

Sensitivity analysis involves examining the sensitivity of the output from an

analysis, such as the NPV estimate, to changes in individual assumptions.

In a sensitivity analysis, an analyst might examine how a projects NPV

changes if there is a decrease in the value of individual cash inflow
assumptions or an increase in the value of individual cash outflow
assumptions.

B.

Scenario analysis will be performed if one wants to examine how the results from
a financial analysis will change under alternative scenarios.

A scenario might describe how a set of project inputs might be different

under different economic conditions.

By comparing the range of NPVs provided by the different scenarios, it is

possible to understand how much uncertainty is associated with an NPV
estimate.

C.

Simulation analysis is like scenario analysis except that in simulation analysis, an

analyst typically uses a computer to examine a large number of scenarios in a
short period of time.

Rather than selecting individual values for each of the assumptionssuch

as unit sales, unit price, and unit variable coststhe analyst assumes that
those assumptions can be represented by statistical distributions.

A computer program then calculates the cash flows associated with a large
number of scenarios by repeatedly drawing numbers for the distributions
for various assumptions, plugging them into the cash flow model, and
computing the annual cash flows and then the NPV.

In addition to providing an estimate of the expected cash flows, simulation

analysis gives information on the distribution of the cash flows that the
project is likely to produce in each year.

12.5

Investment Decisions with Capital Rationing

What does a firm do when it does not have enough money to invest in all available
positive-NPV projects?
o The process of identifying the bundle of projects that creates the greatest total
value and allocating the available capital to these projects is known as capital
rationing.

In an ideal world, the firm could accept all positive-NPV projects, because it
would be able to finance them.
However, the world is not ideal, and so the firm must determine the most

efficient method of allocating its capital.

A.

Capital rationing in a single period involves choosing the set of projects that
creates the greatest value in a given period. The goal is to select the
projects that yield the largest value per dollar invested.
PI
o

Benefits Present Value of Future Cash Flows NPV + Initial Investment

Costs
Initial Investment
Initial Investment

The profitability index (PI) is computed for each project, and the firm then
chooses the projects with the largest profitability indexes until it runs out of
money.

o The objective is to identify the bundle or combination of positive-NPV projects

that creates the greatest total value for stockholders.
o The following steps should be taken:

Calculate the PI for each project.

Rank the projects from highest PI to lowest PI.

Starting at the top of the list (the project with the highest PI) and working
our way down (to the project with the lowest PI), select the projects that
the firm can afford.

Repeat the third step by starting with the second project on the list, the
third project on the list, and so on, to make sure that a more valuable
bundle cannot be identified.

B.

Capital Rationing Across Multiple Periods

If you are planning to make investments over several years, the

investments you choose this year can affect your ability to make
investments in future years.

This can happen if you plan to reinvest some or all of the cash
flows generated by the projects you invest in this year.

A limitation of the profitability index is that it does not tell us enough to

make informed decisions over multiple periods.

II. Suggested and Alternative Approaches to the Material

The focus of Chapter 12 is on the nonfinancially related or operational risks to the firmthat is,
the risks that arise primarily due to the cost structure of the firm rather than the level of debt that
the firm relies on to finance its assets. A large portion of the chapter is allocated to understanding
the effects of operating leverage on a firms break-even as well as the concept of variability
within the estimated revenues, costs, and consequently the net cash flows produced by a project
or the firm. The chapter begins with a descriptive understanding of variable and fixed costs. A
more formal understanding of a firms cost structure is then discussed within an operating
leverage framework where the impact of revenue changes can be evaluated for EBIT or
EBITDA. That understanding is then used to calculate a firms unit break-even from cash, as

well as from an accounting perspective. Those ideas are then used to forecast the impact of input
changes on cash flow by using sensitivity, scenario, and simulation analysis. The chapter then
concludes with a discussion on capital rationing within capital budgeting decisions.
A good portion of the chapter contains material that should be familiar to students who
have completed a managerial accounting course. Therefore the chapter may provide the students
some comfortable ground before they proceed with later chapters, which tend to have a
theoretical basis.

III. Summary of Learning Objectives

1. Explain and be able to demonstrate how variable costs and fixed costs affect the
volatility of pretax operating cash flows and accounting operating profits.
Because the fixed costs associated with a project do not change as revenue changes,
fluctuations in revenue are magnified so that pretax operating cash flows and accounting
operating profits fluctuate more than revenue in percentage terms. The greater the proportion
of total costs that are fixed, the more the fluctuations in revenue will be magnified. To
demonstrate this, you can perform calculations like those in the hammock-manufacturing
example and in Learning by Doing Applications 12.1 and 12.2.

2. Calculate and distinguish between the degree of pretax cash flow operating leverage
and the degree of accounting operating leverage.
The degree of pretax cash flow operating leverage is a measure of how much pretax operating
cash flow will change in relation to a change in revenue. Similarly, the accounting degree of
operating leverage is a measure of how much accounting operating profits will change in
relation to a change in revenue. The only difference between cash flow operating leverage
and accounting operating leverage is that the accounting measure treats incremental
depreciation and amortization charges as a fixed cost in the calculation. These charges are
excluded from the cash flow operating leverage measure because they do not reflect actual
cash expenses and therefore do not affect pretax cash flows. Equations 12.2 and 12.3 are used
to calculate these two measures.

3. Define and calculate the pretax operating cash flow and accounting operating profit
break-even points and the crossover levels of unit sales for a project.
The pretax operating cash flow break-even point is the number of units that must be sold in a
particular year to break even on a pretax operating cash flow basis. It is calculated using
Equation 12.4.
The accounting operating profit break-even point is the number of units that must be sold
in a particular year to break even on an accounting operating profit basis. A project breaks
even on an accounting operating profit basis when it produces exactly $0 in incremental
operating profits, EBIT. It is calculated using Equation 12.6.
The crossover level of unit sales is the level of unit sales at which the pretax operating
cash flows or accounting operating profits for one project alternative switches from being
lower than that of another alternative to being higher. The EBITDA and EBIT crossover
levels of unit sales are calculated using Equations 12.5 and 12.7, respectively.

4.

Define sensitivity analysis, scenario analysis, and simulation analysis and describe
how they are used to evaluate the risks associated with a project.
Sensitivity analysis is concerned with how sensitive the output from a financial analysis, such
as the NPV, is to changes in an individual assumption. It helps identify which assumptions
have the greatest impact on the output and therefore on the value of a project. Knowing this
helps an analyst identify which assumptions are especially important to that analysis.
Scenario analysis is used to examine how the output from a financial analysis changes under
alternative scenarios. This type of analysis recognizes that changing economic and market
conditions affect more than one variable at a time and tries to account for how each of the

different variables will change under alternative scenarios. Simulation analysis is like
scenario analysis except that in simulation analysis a computer is used to examine a large
number of scenarios in a short period of time.

5.

Explain how the profitability index can be used to rank projects when a firm faces
capital rationing, and describe the limitations that apply to the profitability index.
The profitability index (PI) aids in the process of choosing the most valuable bundle of
projects that the firm can afford because it is a measure of value received per dollar invested
that can be used to rank projects in a given period. The major limitation of the PI is that,
while it can be used to rank projects in a given period, it can lead to misleading project
choices in a multiperiod context.

IV. Summary of Key Equations

Equatio
Description

Formula

n
12.1

12.2

12.3

12.4

Op Ex in terms of
incremental
variable and fixed
costs.
Degree of pretax
cash flow operating
leverage
Degree of
accounting
operating leverage
Pretax operating
cash flow breakeven point

Op Ex = VC + FC
Cash Flow DOL = 1

Accounting DOL = 1 +

FC + D&A
.
EBIT

EBITDA Break-Even =

FC
Price - Unit VC

FC Alternative1 - FC Alternative 2

12.5

Crossover level of
unit sales for
EBITDA

CO EBITDA =

12.6

Accounting
operating profit
break-even point

EBIT Break-Even =

12.7

Crossover level of
unit sales for EBIT

CO EBIT =

12.8

Profitability index

PI

V.

FC
.
EBITDA

Unit Contribution Alternative1 - Unit Contribution Alternative 2

FC + D&A
Price - Unit VC

(FC+ D&A) Alternative1 - (FC + D&A) Alternative 2

(Unit Contribution Alternative1 - Unit Contribution Alternative 2 )

NPV + Initial Investment

Initial Investment

Before You Go On Questions and Answers

Section 12.1
1.

Why do analysts care about how sensitive EBITDA and EBIT are to changes in revenue?
Comparing the sensitivity of EBITDA to changes in revenue can help you better

understand risks and returns associated with alternative options. For example, if we assume that
the sensitivity of EBITDA to changes in revenue is higher for one alternative than for the other.
This means that EBITDA for the more sensitive alternative will decline more when revenue is

lower than expected. A larger decline in EBITDA reduces the value of the project more and has a
greater impact on the amount of cash the firm has available to fund other positive NPV projects.
Conversely, EBITDA will increase more when revenue is greater than expected if the level of
sensitivity is higher.

2.

How is the proportion of fixed costs in a projects cost structure related to the sensitivity
of EBITDA and EBIT to changes in revenue?

The greater the proportion of fixed costs, the more sensitive EBITDA and EBIT will be
to changes in revenue.

Section 12.2
1.

How does operating leverage change when there is an increase in the proportion of a
projects costs that are fixed?

An increase in the proportion of a projects costs that are fixed increases the operating
leverage of the project.

2.

What do the degree of pretax cash flow operating leverage (Cash Flow DOL) and the
degree of accounting operating leverage (Accounting DOL) tell us?

Cash Flow DOL provides us with a measure of how sensitive pretax operating cash flows
are to changes in revenue. Cash Flow DOL changes with the level of revenue. Accounting DOL

is a measure of how sensitive accounting operating profits (EBIT) are to changes in revenue.
Accounting DOL focuses on EBIT, whereas Cash Flow DOL focuses on EBITDA.

Section 12.3

1.

How is the per-unit contribution related to the accounting operating profit break-even
point?

The per unit contribution is how much is left from the sale of a single unit after paying
the variable costs associated with that unit. This is the amount that is available to help
cover FC and D&A for the project. When we calculate the accounting operating profit
break-even point, we divide the sum of FC and D&A by the per unit contribution to
determine how many units must be sold to cover FC and D&A.

2.

What is the difference between the pretax operating cash flow break-even point and the
accounting operating profit break-even point?

The operating profit cash flow break even point is the number of units that must be sold
in a particular year for cash inflows to exactly equal cash outflows. The accounting
operating profit break-even point is the number of units that must be sold in a particular
year for the project to have operating profits of $0in other words, to break even on an
accounting operating profit basis.

Section 12.4
1.

How is a sensitivity analysis used in project analysis?

Sensitivity analysis is used to examine the sensitivity of a projects NPV to changes in an

individual assumption.

2.

How does a scenario analysis differ from a sensitivity analysis?

Scenario analysis recognizes that variables typically do not change one at a time. A
change in economic or market conditions will usually cause several assumptions to
change. Scenario analysis recognizes this by examining a project under alternative
scenarios in which each assumption can change under each scenario.

3.

What is a simulation analysis, and what can it tell us?

Simulation analysis is like scenario analysis in that it enables the analyst to evaluate the
effects of different scenarios. A key difference is that simulation analysis uses computers
to enable the analyst to examine a large number of scenarios in a short period of time.

Section 12.5
1.

What decision criteria should managers use in selecting projects when there is not
enough money to invest in all available positive-NPV projects?

When a firm does not have enough money to invest in all available positive-NPV
projects, managers should identify the bundle of positive-NPV projects that creates the
greatest total value for stockholders.

2.

What might cause a firm to face capital constraints?

A firm might face capital constraints because it can be difficult for outside investors (new
creditors, bondholders, or stockholders) to accurately assess the risks and returns
associated with the firms projects. This might cause the investors to require returns for
their capital that are so high that they make positive-NPV projects unattractive, because
those projects cannot produce the high returns required by investors.

3.

How can the PI help in choosing projects when a firm faces capital constraints? What are
its limitations?

The basic principle is to select the projects that yield the largest NPV per dollar invested.
The PI tells us the NPV per dollar invested for an individual project. In a single
period, the PI can be used to identify the bundle of projects that yields the largest NPV
per dollar invested. However, as illustrated in Section 12.5, the PI will not necessarily
help identify the most valuable bundle of projects if investments are being compared
across more than one year and the timing of cash flows from early investments affects the
firms ability to make subsequent investments.

VI. Self-Study Problems

12.1

The Yellow Shelf Company sells all of its shelves for $100 per shelf, and incurs $50 in
variable costs to produce each. If the fixed costs for the firm are $2 million per year, then
what will the EBIT be for the firm if it produces and sells 45,000 shelves next year?
Assume that depreciation and amortization is included in the fixed costs.

Solution:
Revenue
VC

$100 x 45,000 =

$4,500,000

$50 x 45,000 =

2,250,000

FC + D&A

2,000,000

EBIT

12.2

$ 250,000

Hydrogen Batteries sells its specialty automobile batteries for $85 each, while its current
variable cost per unit is $65. Total fixed costs (including depreciation and amortization
expense) are $150,000 per year. The firm expects to sell 10,000 batteries next yea,r but
the firm is concerned that its variable cost will increase next year due to material cost
increases. What is the maximum variable cost per unit increase that will keep the EBIT
from becoming negative?

Solution:
The forecasted EBIT for the firm is:
Revenue

$85 x 10,000 =

$850,000

VC

$65 x 10,000 =

FC + D&A

650,000
150,000

EBIT

$ 50,000

Therefore, total variable cost may increase by $50,000, which means that if the firm
produces and sells 10,000 batteries, then the variable cost per unit may increase by $5
($50,000 / 10,00) units.

12.3

The Vinyl CD Co. is going to take on a project that will increase its EBIT by $90,000
next year. The firms fixed cost cash expenditures are expected to increase by $100,000,
and depreciation and amortization will increase by $80,000 next year. If the project just
happens to yield an additional 10 percent in revenue, what percentage increase in the
projects EBIT will result from the additional revenue?

Solution:
Accounting DOL = 1 + (FC+ D&A) / (EBIT)
= 1 + ($100,000 + $80,000) / $90,000
=3
Therefore, a 10 percent additional increase in revenue should result in a 30 percent
increase in EBIT.

12.4

You are considering investing in a business that has monthly fixed costs of $5,500 and
that sells a single product that costs $35 per unit make. This product sells for $90 per
unit. What is the annual pretax operating cash flow break-even point for this business?

Solution:
You can solve for the monthly pretax operating cash flow break-even point using
Equation 12.4:
EBITDA Break-Even =

FC
$5,500

100 units
Price - Unit VC $90 $35

Therefore, the annual EBITDA break-even point is 100 12 = 1,200 units.

12.5

You are considering a project that has an initial outlay of $1 million. The profitability
index of the project is 2.24. What is the NPV of the project?

Solution:
You can use Equation 12.8 to solve for the NPV:
PI

= (NPV + Initial investment) / Initial investment

2.24

= NPV + $1,000,000 / $1,000,000

Therefore:
NPV = $2,240,000

VII. Critical Thinking Questions

12.1

You are planning for a firm that is expected to have a large increase in sales for the next
year. Which type of firm would benefit the most from that sales increase, the firm with

low fixed costs and high variable costs or the firm with high fixed costs and low variable
costs?

Solution:
Under the circumstances described, the firm with the high fixed costs would incur lower
total future costs associated with the increased sales than the firm with the low fixed costs
due to the higher variable cost per unit of sales. Therefore, the firm with the high fixed
costs structure would benefit the most.

12.2

You own a firm with a single new product that is about to be introduced to the public for
the first time. Your marketing analysis suggests that the demand for this product could be
anywhere between 500,000 units and 5,000,000 units. Given such a wide dispersal
concerning the demand forecast, discuss the safest cost structure alternative for your firm

Solution:
Since there is a great deal of variability concerning the demand for the product, then the
safest alternative would be to create a cost structure that limits the variability of the firms
EBIT. This means that you would create a cost structure that is composed of high unit
variable costs with low fixed costs. Although this would not enable the firm to maximize
earnings if the 5,000,000 unit forecast occurs, it limits the downside profitability for the
firm in the event that the 500,000 unit forecast occurs.

12.3

Define capital rationing, and explain why it can occur in the real world.

Solution:
Capital rationing is the process of allocating limited capital among the positive-NPV
projects that have been identified in a way that maximizes the overall NPV of the projects
selected. In an ideal world, we should accept all positive NPV projects because we will
always be able to finance them. However, the world is not ideal. It can be difficult for
outside investors to accurately assess the risks and returns associated with a project. With
limited capital available for new projects, we need capital rationing to help us decide how
to allocate capital among all potential investments.

12.4

Discuss the interpretation of the degree of accounting operating leverage and cash flow
degree of operating leverage.

Solution:
While the degree of accounting operating leverage is defined as:
Accounting DOL = 1 + (FC + D&A) / (EBIT)
it is used to interpret the percentage change in EBIT that will be driven by a given
percentage change in net revenue. Similarly, the cash flow degree of operating leverage is
defined as:
Cash Flow DOL = 1 + FC / (EBIT + D&A)
but it is used to interpret the percentage change in EBITDA (or pretax operating cash
flow) that will be driven by a given percentage change in net revenue.

12.5

Explain how EBITDA differs from free cash flows, FCF, and discuss the types of
businesses for which this difference would be especially small or large.

Solution:
Depreciation and amortization, taxes, capital expenditures, and working capital are not
reflected in EBITDA. If any of these is not equal to zero, then EBITDA is likely to differ
from FCF, which is equal to EBIT(1-T) + depreciationincreases in working capital
capital expenditures. The type of businesses that require large capital expenditures (and
therefore have large depreciation expenses per year) such as heavy manufacturing, are
likely to have substantial differences between EBITDA and FCF. Conversely, smaller
firms that have smaller capital expenditures, such as firms in retail sales, will likely have
small differences between FCF and EBITDA for. Setting aside depreciation and special
tax subsidies, taxes will always create a difference between EBITDA and FCF for a
profitable firm.

12.6

Describe how the cash flow break-even point calculated in this chapter is related to a
break-even point that makes the NPV of a project equal to zero.

Solution:
The cash flow break-even point calculated in this chapter establishes the number of units
that must be sold in a given year to break even for a particular year. The NPV break-even
calculation looks at cash flows over the course of an entire project and tells us how many
units must be sold to achieve an NPV of $0. The NPV calculation is useful when deciding

whether to undertake a project in an economic sense. The cash flow break-even

calculation is useful when considering whether to abandon a project or to make changes
to a projects cost structure.

12.7

Is it possible to have a crossover point, where the accounting break-even is the same for
two alternatives, that is, above the break-even point for a low-fixed-cost alternative but
below the break-even point for a high-fixed-cost alternative? Explain.

Solution:
No. Above the low fixed cost break-even sales level implies that income is positive.
Below the high fixed cost break-even sales level implies that income is negative.
However, the cross-over point is defined as the sales level at which the income level for
both alternatives is the same. Therefore, it cannot occur.

12.8

In calculus we are able to understand the effect of a change to a single variable, within a
multivariable equation, on the entire equation. We call that effect the partial derivative.
Which is analogous to the partial derivative: sensitivity analysis, scenario analysis, or
simulation analysis?

Solution:
Simulation measures the effect of many variables moving at once in order to help with
statistical inference. Scenario analysis also measures the effect of many variables moving
together in a semicoordinated way and it is therefore not analogous to a partial derivative.

Sensitivity analysis measures the effect of a change in a single variable on the income
statement, or even some other financial output, regardless of whether it is even possible
for that variable to move independently without a co-movement in an another variable.
Therefore, sensitivity analysis is most analogous to the partial derivative in calculus.

12.9

High Tech Monopoly Co. has plenty of cash to fund any conceivable positive NPV
project. Can you describe a situation in which capital rationing could still occur?

Solution:
Financial capital is not the only constrainable item within the firm. This might occur, for
example, when human capital is in short supply, as is the case with most high-technology
firms. Even if every positive NPV project could be funded, the firm might not have
enough employees to manage the projects. Therefore, even with ample financial capital,
firms will more than likely still be rationing projects.

12.10 Profitability index is a scaleless attribute for measuring a projects benefits, relative to the
costs. How might this help to eliminate bias in project selection?

Solution:
Since the profitability index is a modified pure-return-type measure, it offers a method to
maximize the use of capital that is employed by the firm. This could help eliminate some
types of bias if the measure were to be employed universally. However, it does not

necessarily maximize the use of capital that is not employed, which could in some
circumstances be problematic.

VIII.

Questions and Problems

BASIC
12.1

Fixed and variable costs: Define variable costs and fixed costs and give an example of
each.

Solution:
Fixed costs are costs that in the short term cannot be changed regardless of how much
output the project produces. One example is the first advertising contract discussed in
Learning by Doing Application 12.1. Regardless of the number of house calls the
technical support firm makes, it will incur the full cost of advertising. Variable costs are
costs that depend on the number of units of output produced by the project. An example
is the gas that the technical support firm uses to make house calls. The cost to keep the
vehicles gassed up is directly related to the number of service calls the firm makes.

12.2

EBIT: Describe the role that the mix of variable versus fixed costs has in the variation of
Earnings before interest and taxes (EBIT) for the firm.

Solution:
By definition, variable costs do not occur unless matching sales or matching revenues
also occur, whereas fixed costs are not a function of the level of sales. Therefore, a large
mix of fixed costs within a firms cost structure will make the firms EBIT very reactive to
a change in the level of sales for the firm. The greater the proportion of fixed costs
(compared to variable costs), the greater the variability in EBIT for the firm.

12.3

EBIT: The Generic Publications Text Book Company sells all of its books for $100 per
book, and it currently costs $50 in variable costs to produce each text. The fixed costs,
which include depreciation and amortization for the firm, are currently $2 million per
year. The firm is considering changing its production technology, which will increase the
fixed costs for the firm by 50 percent but decrease the variable costs per unit by 50
percent. If 45,000 books are expected to be sold next year, should the firm switch
technologies?

Solution:
The current EBIT for the firm is:
Revenue
VC

$100 x 45,000 =

$4,500,000

$50 x 45,000 =

2,250,000

FC + D&A

2,000,000

EBIT

$ 250,000

If the fixed costs increase by 50 percent, then they will be $2,000,000 x 1.5 = $3,000,000,
while the unit variable costs would be .5 x $50 = $25.

The new EBIT for the firm would then be:

Revenue
VC

$100 x 45,000 =

$4,500,000

$25 x 45,000 =

1,125,000

FC + D&A

3,000,000

EBIT

$ 375,000

Since the EBIT after the technology change is $125,000 higher, then the firm should
adopt the new production technology.
12.4

EBIT: WalkAbout Kangaroo Shoe Stores forecasts that they will sell 9,500 pairs of shoes
next year. The firm buys its shoes for $50 per pair from the wholesaler and sells them for
$75 per pair. If the firm will incur fixed costs plus depreciation and amortization of
$100,000, then what is the percentage increase in EBIT if the actual sales next year equal
11,500 pairs of shoes?

Solution:
The forecasted EBIT for the firm is:
Revenue

$75 x 9,500 =

$712,500

VC

$50 x 9,500 =

475,000

FC + D&A

100,000

EBIT

$137,500

The actual EBIT for the firm is:

Revenue

$75 x 11,500 =

$862,500

VC

$50 x 11,500 =

575,000

FC + D&A

100,000

EBIT

$187,500

Therefore, the percent increase in EBIT would be ($187,500 $137,500) / $137,500 =

0.3636 = 36.36%.

12.5

Cash Flow DOL: The law firm of Dewey, Cheatem, and Howe has monthly fixed costs
of $100,000, EBIT of $250,000, and depreciation charges on its office furniture and
computers of $5,000. Calculate the Cash Flow DOL for this firm.

Solution:
Cash Flow DOL Automoted = 1 +

12.6

FC
$100,000
=1+
= 0.392.
EBITDA
$250,000 + $5,000

Accounting DOL: Explain how the value of accounting operating leverage can be used.

Solution:
Accounting operating leverage gives us the ratio by which the firm can convert revenues
into EBIT. That is, if the firms operating leverage is 3, then a 15 percent increase will
convert to a 45 percent (15% x 3) increase in EBIT for the firm.

12.7

Break-cven analysis: Why is the per-unit contribution important in a break-even

analysis?

Solution:
Per-unit contribution is critical to break-even analysis in order for a firm to determine how
many units are required to be sold to cover the firms fixed costs. The underlying known
variable is the dollar amount of the contribution margin the firm will generate from each
unit sold in order to make the above calculation. Equations 12.4 and 12.6 demonstrate the
calculation for EBITDA and EBIT break-even points. The term in the denominator (PriceUnit VC) represents the per-unit cash flow contribution.

12.8

Simulation analysis: What is simulation analysis and how is it used?

Solution:
Simulation analysis is like scenario analysis except that in simulation analysis an analyst
typically uses a computer to examine a large number of scenarios in a short period of
time. Rather than selecting individual values for each of the assumptionssuch as unit
sales, unit price, and unit variable coststhe analyst assumes that those assumptions can
be represented by statistical distributions. The computer then draws upon the distribution
of each variable in order to generate an observation for a single scenario. After repeating
the number of computer-generated scenarios, a distribution of cash flow outcomes will be
generated, thereby offering the analyst the ability to perform a probability-based analysis
on the cash flow distribution.

12.9

Profitability index: What is the profitability index, and why is it helpful in the capital
rationing process?

Solution:
The profitability index is computed as the ratio of NPV plus initial investment to initial
investment. In the capital rationing process, we can calculate the profitability index for
each potential investment and choose the projects with the largest indexes until we run
out of capital. This follows the basic principle that we need to choose the set of projects
that creates the greatest value given the limited capital available.

INTERMEDIATE
12.10 EBIT: If a manufacturing firm and a service firm have identical cash fixed costs but the
manufacturing firm has much higher depreciation and amortization, then which firm is
more likely to have a large discrepancy between its FCF and its EBIT?

Solution:
Since depreciation and amortization is a noncash item, the manufacturing firm would
have the greatest discrepancy between FCF and EBIT.

12.11 EBIT: Duplicate Baseballs, Inc., expects to sell 15,000 balls this year. The balls sell for
$110 each and have variable cost per unit of $80 per ball. Fixed costs, including
depreciation and amortization, are currently $220,000 per year. How much can either the

fixed costs increase or the variable cost per unit increase in order to keep the company
from having a negative EBIT.

Solution:
The forecasted EBIT for the firm is:
Revenue
VC
FC + D&A
EBIT

$110 x 15,000 =

$1,650,000

$80 x 15,000 =

1,200,000
220,000
$ 230,000

Therefore, the fixed costs could increase by $230,000 and still keep the EBIT from being
negative. If we focus on the variable costs, we know that total variable costs could
increase by $230,000. If that cost is spread over 15,000 units, then the variable cost per
unit could increase by ($230,000 / 15,000) = $15.33 and still keep the EBIT from being
negative. Note that the analysis assumes that increases in either the fixed cost or the
variable cost per unit will not change the other. This is probably not a realistic
assumption.

12.12 EBIT: Specialty Light Bulbs anticipates selling 3,000 light bulbs this year at a price of
$15 per bulb. It costs Specialty $10 in variable costs to produce each light bulb, and the
fixed costs for the firm are $10,000. Specialty has an opportunity to sell an additional
1,000 bulbs next year at the same price and variable cost, but by doing so the firm will
incur an additional fixed cost of $4,000 if it chooses to sell the additional bulbs. Should
Specialty produce and sell the additional bulbs?

Solution:
The forecasted EBIT for the firm is:
Revenue

$15 x 1,000 =

$15,000

VC

$10 x 1,000 =

10,000

FC

4,000

EBIT

$ 1,000

Since the EBIT is positive, then Specialty should produce and sell the additional bulbs.
12.13 Cash Flow DOL: For the Vinyl CD Co. in Self-Study Problem 12.3, what percentage
increase in pretax operating cash flow will be driven by the additional revenue?

Solution:
Cash flow DOL

= 1 + (FC) / (EBIT + D&A)

=1 + ($100,000) / ($90,000 + $80,000) = 1.59

Therefore, a 10 percent additional increase in revenue should drive a 15.9 percent

increase in pretax operating cash flow.

Use the following information for Problems 12-14, 12-15, and 12-16:
Dandles Candles will be producing a new line of dripless candles in the coming years and has the
choice of producing the candles in a large factory with a small number of workers or a small
factory with a large number of workers. Each candle will be sold for $10. If the large factory is
chosen, the cost per unit to produce each candle is $2.50, while it will be $7.50 for the small

factory. The large factory would have fixed cash costs of $2,000,000 and a depreciation expense
of $300,000 per year, while those expenses would be $500,000 and $100,000 in the small factory.
12.14 Accounting operating profit break-even: Calculate the accounting operating profit
break-even point for both factory choices for Dandles Candles.

Solution:
The formula for the accounting operating profit break-even is:
EBIT break-even = (FC + D&A) / (Price Unit VC)
For the large factory:
EBIT break-even = ($2,000,000 $300,000)/ ($10 $2.50) = 306,667 units
For the small factory:
EBIT break-even = ($500,000 $100,000) / ($10 $7.50) = 240,000 units

12.15. Crossover level of unit sales: Calculate the number of candles for Dandles Candles for
which the Accounting Break-even is the same, regardless of the factory choice.

Solution:
The formula for the crossover level of units sales (CO) is:
CO

CO

FC D & A Alternative1 FC D & A Alternative 2

Unit Contribution Alternative1 Unit Contribution Alternative 2

$2,300,000 $600,000
340,000 units
($10 $2.5) ($10 $7.5)

CO = 340,000 units

12.16 Pretax operating cash flow break-even: Calculate the pretax operating cash flow
break-even point for both factory choices for Dandles Candles.

Solution:
The formula for the pretax operating cash flow break-even is:
CF Break-even = FC / (Price Unit VC)
and so the cash flow break-even for the large factory is:
CF Break-even = $/ ($10 $2.5) = 266,667 units
and the cash flow break-even for the small factory is:
CF Break-even = $/ ($10 $7.5) = 200,000 units

12.17 Accounting and cash flow break-even: Your analysis tells you that at a projected level
of sales, your firm will be below accounting break-even but will be above cash flow
break-even. Explain why this might still be a viable project or firm.

Solution:
While the business may show an accounting loss, our focus should be on the cash flow
gain or loss. The reason that the project will produce an accounting loss but cash flow
income is that the depreciation and amortization charges do not apply to the cash flow

calculations as they are noncash expenses that help to reduce the tax liability. Therefore,
the project is viable if it does not show a cash flow loss.

12.18 Sensitivity and scenario analyses: Sensitivity analysis and scenario analysis are
somewhat similar. Describe which is a more realistic method of analyzing different
scenario impacts on a project.

Solution:
Sensitivity analysis captures the effect of a change in a single item such as unit selling
price or a change in the number of units sold on a specific item such as EBIT. However, it
is unlikely that a change in the selling price of an item will not affect the demand, and
consequently the number of units sold, for the product in question. Scenario analysis
analyzes the multiple effects of a scenario on an item such as EBIT by changing a
number of interrelated variables at the same time to measure the effect of an entire
scenario change. Therefore, scenario analysis is a much more practical tool for stresstesting a project.

12.19 Sensitivity analysis: Describe the circumstances under which sensitivity analysis might
be a reasonable basis for determining changes to a firms EBIT or FCF.

Solution:

Since sensitivity analysis assumes independence among variables (otherwise the analysis
is too superficial), then that is the time when the analysis can yield the most meaningful
results. One time when that might occur is if the sales level and product price are
completely unaffected by movements in the other as with an industry monopoly. In a
competitive market, such an assumption could yield disastrous results if they are
followed without caution.

12.20 Scenario analysis: Chips Home Brew Whiskey forecasts that if it sells each bottle of
Snake-Bite for $20, then the demand for the product will be 15,000 bottles per year. If
Chip sells Snake-Bite for a 10 percent higher price, then it believes that it will sell 90
percent of the amount of its pre-hike-priced product. Chips variable cost per bottle is
$10, and the total fixed cash cost for the year is $100,000. Depreciation and amortization
charges are $20,000, and the firm is in the 30 percent marginal tax rate. If the firm
anticipates an increased working capital need of $3,000 for the year, then what will be
the effect of a price increase on the firms FCF for the year?

Solution:
If the firm increases its price to $22 per bottle, then it will sell 0.9 x 15,000 = 13,500
units next year. We can now find the effect of the change in price.
Normal
Revenue

Price Hike

$300,000

$297,000 (22 x 13,500)

VC

150,000

135,000 (10 x 13,500)

FC

100,000

100,000

D&A

20,000

20,000

EBIT

$ 30,000

$ 42,000

9,000

12,600

$ 21,000

$ 29,400

Tax (30%)
NOPAT
D&A
Add WC
FCF

20,000

20,000

3,000

3,000

$ 38,000

$ 46,400

By increasing the price of a bottle by 10 percent, the FCF increases from $38,000 to
$46,400.

12.21 Simulation analysis: If you were interested in calculating the probability that your
project will have positive FCF, what type of risk analysis tool would you most likely use?

Solution:
Sensitivity analysis can only manage a single movement in a modeled variable and can
therefore only show the net impact of that movement. Scenario analysis is much more
flexible and can quantify the impact of moving many interdependent variables at once,
but it cannot produce confidence intervals for a given level of FCF. Simulation analysis
begins with a distribution for the range of possible values for each variable. All of these
modeled variables are then freed up to randomly move, all at the same time, within the
modeled range in order to produce an individual observation. If this process is repeated a
large number of times, then a distribution of observations is generated for the FCF value

(or EBIT or a whole host of other calculations) in order to be able to make statistical
inferences about the probability of achieving a given level of FCF.

12.22 Profitability index: Suppose that you faced the following projects but only have $30,000
to invest. How would you make your decision?
Project

Cost ($)

NPV ($)

$ 8,000

$4,000

11,000

7,000

9,000

5,000

7,000

4,000

Solution:
The profitability indexes of the projects are:
A: 1.5; B: 1.64; C: 1.56; D: 1.57
With $30,000, you should invest in B, D, and C. The total cost is $27,000, and the total
NPV is $16,000.

12.23 Profitability index: Suppose that you face the same following projects as in the previous
problem, but now only have $25,000 to invest. How would you make your decision?

Solution:
The profitability indexes of the projects are:
A: 1.5; B: 1.64; C: 1.56; D: 1.57

With $25,000, you cannot invest in all of B, D, and C, since the total cost is $27,000. You
may think that you should then invest in only B and D, since they have the highest
profitability indexes. This will yield a total NPV of $11,000, and you are left with $7,000
of idle capital.
If you give up project B, however, which has the highest profitability index and
highest cost, and invest instead in A, C, and D, which require less capital, you will get a
total NPV of $13,000, and you are left with less idle capital ($6,000). From this example
you can see that capital rationing with indivisible projects are sometimes complicated and
require a careful thought of all possibilities (or linear/integer programming).

ADVANCED
12.24 Micks Soft Lemonade is starting a new product for which the fixed cash expenditures are
expected to be $80,000. The projected EBIT is $100,000, and the accounting DOL will be
2.0. What is the cash flow DOL for the firm?

Solution:
Accounting DOL = 1 + (FC + D&A) / (EBIT)
= 1 + ($80,000 + D&A) / $100,000 = 2 => D&A = $20,000
Cash flow DOL = 1 +(FC) /(EBIT + D&A
= 1 + ($80,000) / ($100,000 + $20,000) = 1.67

12.25 If a firm has any reasonable fixed asset base, meaning that its depreciation and
amortization for any year is positive, discuss the relationship between a firms Accounting
DOL and its Cash flow DOL.

Solution:
By comparing the equations for the Accounting DOL and Cash Flow DOL:
Accounting DOL = 1 +(FC + D&A) / (EBIT)
Cash flow DOL = 1 +(FC) / (EBIT + D&A)
We find that the denominator of the Cash Flow DOL will always be greater than the
denominator of the Accounting DOL if depreciation and amortization is greater than zero.
In addition, the numerator of the Cash Flow DOL will always be less than the
denominator of the Accounting DOL if depreciation and amortization is greater than zero.
Therefore, if depreciation and amortization is positive, then Cash Flow DOL must be less
than Accounting DOL.

12.26 DOL and Cash Flow DOL: Silver Polygon, Inc., has determined that if its revenues
were to increase by 10 percent, then its change in EBIT would increase by 25 percent to
$100,000. The fixed costs (cash only) for the firm are $100,000. Given the same 10
percent increase in revenues, what would be the corresponding change in EBITDA?

Solution:
Since a 10 percent increase in revenue will drive a 25 percent corresponding increase in
EBIT, then we know that Accounting DOL = 2.5. The new EBIT would be 100,000, after

the 25 percent increase, so the original EBIT was 100,000 / (1 + 0.25) = $80,000.
Therefore,
Accounting DOL = 1 + (FC + D&A) / (EBIT) = 2.5
= 1 +($100,00 + D&A) / ($80,000) = 2.5 ==> D&A = $20,000
Cash Flow DOL = 1 + (FC) / (EBIT + D&A) =
= 1 + ($100,000) / ($80,000 + $20,000) = 1.20
A 10 percent increase in revenue will drive a 12 percent increase in EBITDA.

12.27 If a firms costs are absolutely known (variable as well as fixed), then what are the only
two sources of volatility for a firms accounting profits or its cash flows?

Solution:
If the cost structure is known, then costs will only vary according to the firms unit sales.
Therefore, one source of volatility would be net revenue uncertainty. The second source
of volatility is based on the mix of variable and fixed costs within the firms cost
structure. A higher mix of fixed costs would increase the operating leverage for a firm
(both accounting and cash flow) and therefore increase the accounting profit and cash
flow volatility for the firm.

12.28 In most circumstances, if a firm were given the choice of a higher fixed cost structure
versus a lower fixed cost structure, which of the two would generate a larger contribution
margin?

Solution:
The firm with the higher fixed cost should have a lower variable cost per unit, assuming
that there is a trade-off. A lower variable cost per unit would then create a higher
contribution margin for that firm.

12.29 Using the same logic as with the accounting break-even calculation in Problem 12.15,
adapt the formula for cross-over level of unit sales to find the number of units sold where
the free cash flow is the same whether the firm chooses the large or small factory.

Solution:
The formula for the cross-over level of unit sales, based on accounting EBIT, is as
follows:
CO=

FC+D&A Alternative1 - FC+D&A Alternative2

Unit Contribution Alternative1 - Unit Contribution Alternative2 .

Since depreciation and amortization are noncash items, we could adapt the above formula
by omitting the depreciation and amortization from the numerator of the above formula
as below:
The formula for FCF in terms of unit contribution is given by:

FCF1 Units Unit Contributi on 1 - FC1 1 t t D & A Cap Ex 1 WC1

By setting FCF1 = FCF2 and solving for the common number of units, we get:

CO

1 - t FC1 - FC 2 t D & A 2 - D & A1 CapEx 1 - CapEx 2 WC1 - WC 2

1 - t UnitContri bution 1 - UnitContr ibution 2

12.30 You are analyzing two proposed capital investments with the following cash flows:
Year
0

Project X ($)
$(20,000)

Project Y ($)
$(20,000)

13,000

7,000

6,000

7,000

6,000

7,000

2,000

7,000

The cost of capital for both projects is 10 percent. Calculate the NPV and the profitability
index (PI) for each project. Which project, or projects, should be accepted if you have
unlimited funds to invest? Which project should be accepted if they are mutually
exclusive?

Solution:
The NPV and PI calculations are as follows:
$13,000 $6,000 $6,000 $2,000

$2,650.78
(1.1)1
(1.1) 2
(1.1) 3
(1.1) 4
$7,000 $7,000 $7,000 $7,000
NPVy $20,000

$2,189.06
(1.1)1
(1.1) 2
(1.1) 3
(1.1) 4
NPVx $20,000

NPV + Initial Investment $22, 650.78

1.1325
Initial Investment
$20, 000
NPV + Initial Investment $22,189.06
PI y

1.1095
Initial Investment
$20, 000
PI x

Both methods rank Project X over Project Y. However, both projects should be accepted
under the NPV criteria. Therefore, both should be accepted if they are independent and
sufficient resources are available. If the projects are mutually exclusive, we should
choose the project with the higher NPV or PI at r = 10%, which in this case is Project X.
We can directly compare the NPVs because both projects have four-year lives.

CFA Problems
12.31 An investment of $20,000 will create a perpetual after-tax cash flow of $2,000. The
required rate of return is 8 percent. What is the investments profitability index?
A.
1.00
B.
1.08
C.
1.16
D.
1.25
Solution
D is correct.
2,000
The present value of future cash flows is PV = 0.08 = 25,000.

PV
25, 000

The profitability index is PI = Investment 20, 000 =1.25.

12.32. Hermann Corporation is considering an investment of 375 million with expected aftertax cash inflows of 115 million per year for seven years and an additional after-tax
salvage value of 50 million in Year seven. The required rate of return is 10 percent.
What is the investments PI?
A.
1.19
B.
1.33
C.
1.56
D.
1.75
Solution
C is correct.

115
50

t
1.107 = 585.53 million euros
t 1 1.10

PV
PI

585.53
375 =1.56

12.33. Operating leverage is a measure of the

A.
sensitivity of net earnings to changes in operating earnings.
B.
sensitivity of net earnings to changes in sales.
C.
sensitivity of fixed operating costs to changes in variable costs.
D.
sensitivity of earnings before interest and taxes to changes in the number of
units produced and sold.
Solution:
D is correct. Operating leverage is the sensitivity of earnings before interest and taxes to changes
in the number of units produced and sold. The degree of operating leverage is the
elasticity of operating earnings with respect to the number of units produced and sold.
12.34. The Fulcrum Company produces decorative swivel platforms for home televisions. If
Fulcrum produces 40 million units, it estimates that it can sell them for $100 each. The
variable production costs are $65 per unit, whereas the fixed production costs are $1.05
billion. Which of the following statements is true?
A.
The Fulcrum Company produces a positive operating income if it produces
and sells more than 25 million swivel platforms.
B.
The Fulcrum Companys degree of operating leverage is 1.333.
C.
If the Fulcrum Company increases production and sales by 5 percent, its
operating earnings are expected to increase by 20 percent.
D.
Increasing the fixed production costs by 10 percent will result in a lower
sensitivity of operating earnings to changes in units produced and sold.
Solution:

C is correct.
DOL =

40 million($100 $65)
$1.05 billion

40 million($100 $65)

$1.400 billion
$1.400 billion $1.05 billion
$1.4
=
$0.35
=4
=

Operating breakeven =

$1.05 billion
= 30 million units
$35

Fulcrum produces positive operating income if it produces more than 30 million units. If
it produces and sells fewer than 30 million, it will generate a loss.
The DOL is 4.
If unit sales increase by 5 percent, Fulcrums operating earnings are expected to increase
by 4 5% = 20%.
Increasing fixed production costs will increase the sensitivity of Fulcrums operating
earnings to changes in sales.

Sample Test Problems

12.1. Stevens Hats forecasts that it will sell 25,000 baseball caps next year. The firm buys its
caps for $3 from the wholesaler and sells them for $15 each. If the firm will incur fixed
costs plus depreciation and amortization of $80,000, then what is the percentage increase
in EBIT if the actual sales next year equal 27,000 caps?

Solution:
The forecasted EBIT for the firm is:
Revenue
VC

$15 x 25,000 =

$375,000

$3 x 25,000 =

75,000

FC + D&A

80,000

EBIT

$220,000

The actual EBIT for the firm is:

Revenue
VC
FC + D&A
EBIT

$15 x 27,000 =

$405,000

$3 x 27,000 =

81,000
80,000
$244,000

Therefore, the percent increase in EBIT would be ($244,000 $220,000) / $220,000 =

0.1091 = 10.91%.
12.2

Alans Fine Furniture will be creating custom bed frames, and the fixed cash expenditures
are expected to be $120,000. The projected EBIT for the project is $130,000, and the
accounting DOL will be 2.5. What is the depreciation and amortization for the firm as
well as Cash Flow DOL?

Solution:
Accounting DOL = 1 + (FC + D&A) / (EBIT)
= 1 + ($120,000 + D&A) / $130,000 = 2.5 => D&A = $75,000
Cash Flow DOL = 1 + (FC) / (EBIT + D&A)
= 1 + ($120,000) / ($130,000 + $75,000) = 1.59
12.3

Red Cat Firecrackers is considering whether to build a large or small factory to produce
its firecrackers. Regardless of the production method, each bundle of firecrackers sells for
$4.00. If the large factory is chosen, then the variable cost per bundle of firecrackers will
be $0.50, while the fixed costs will be $300,000 and the annual depreciation and
amortization amount will be $100,000. If the small factory is chosen, then the variable
cost per bundle of firecrackers will be $1.75 while the fixed costs will be $100,000 and
the annual depreciation and amortization amount will be $10,000. Calculate the number
of firecracker bundles for Red Cat such that the accounting operating profit is the same,
regardless of the factory choice.

Solution:

The formula for the cross-over level of unit sales (CO) is:

CO

CO

12.4

FC D & A Alternative1 FC D & A Alternative 2

Unit Contribution Alternative1 Unit Contribution Alternative 2 , and so

$400,000 $110,000
232,000 bundles
($4 $.5) ($4 $1.75)

You are chairperson of the investment committee at your firm. Five projects have been
submitted to your committee for approval this month. The investment required and the
project profitability index for each of these projects are presented in the following table:
Project

Investment ($)

PI ($)

$20,000

2.500

50,000

2.000

70,000

1.750

10,000

1.000

80,000

0.800

If you have $500,000 available for investments, which of these projects would you
approve? Assume that you do not have to worry about having enough resources for future
investments when making this decision.

Solution:

Definitely accept projects A, B, and C. They all have a positive NPV. Project D just
returns the opportunity cost of capital, so you would be indifferent with regards to
accepting this project. Do not accept project E; it has a negative NPV.

12.5

Ibrahims Habanero Sauce Products forecasts that if it sells each bottle of NitroStrength
for $10, then the demand for the product will be 85,000 bottles per year. If it sells SnakeBite for a 10 percent higher price, then it believes that it will sell 75 percent of the
amount of its pre-hike-priced product. Ibrahims variable cost per bottle is $4, and the
total fixed cash cost for the year is $20,000. Depreciation and amortization charges are
$3,000, and the firm is in the 40 percent marginal tax rate. If the firm anticipates an
increased working capital need of $2,000 for the year, then find the effect of a price
increase on the firms FCF for the year.

Solution:
If the firm increases its price to $11 per bottle, then it will sell 0.75 x 85,000 = 63,750
units next year. We can now find the effect of the change in price.

Normal
Revenue

Price Hike

$850,000

$701,250 (11 x 63,750)

VC

340,000

255,000 (4 x 63,750)

FC

20,000

20,000

D&A

3,000

3,000

EBIT

$487,000

$423,250

Tax (40%)

194,800

169,300

$292,200

$253,950

D&A

3,000

3,000

Add WC

2,000

2,000

$293,200

$254,950

NOPAT

FCF

By increasing the price of a bottle by 10 percent, the FCF decreases from $293,200 to
$254,950.