QUESTIONS AND PROBLEMS

BASIC
(Q uestions 1–15)
1. Calculating Costs and Break-Even [ LO3] Night Shades, Inc., manufactures biotech Page 382
sunglasses. The variable materials cost is $12.14 per unit, and the variable labor cost is
$6.89 per unit.
a. What is the variable cost per unit?
b. Suppose the company incurs fixed costs of $845,000 during a year in which total production is
210,000 units. What are the total costs for the year?
c. If the selling price is $49.99 per unit, does the company break even on a cash basis? If
depreciation is $450,000 per year, what is the accounting break-even point?
2. Computing Average Cost [ LO3] Ojo Outerwear Corporation can manufacture mountain
climbing shoes for $45.17 per pair in variable raw material costs and $29.73 per pair in variable
labor expense. The shoes sell for $210 per pair. Last year, production was 155,000 pairs. Fixed costs
were $2.15 million. 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 5,000 pairs, what is
the minimum acceptable total revenue from the order? Explain.
3. Scenario Analysis [ LO2] Stinnett Transmissions, Inc., has the following estimates for its new
gear assembly project: Price = $1,220 per unit; variable costs = $380 per unit; fixed costs = $3.75
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?
4. Sensitivity Analysis [ LO1] 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? Describe how you would calculate your answer. What values would you use
for the other forecast variables?
5. Sensitivity Analysis and Break-Even [ LO1, 3] We are evaluating a project that costs
$845,000, has an eight-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 51,000 units per year. Price per unit is $53,
variable cost per unit is $27, and fixed costs are $950,000 per year. The tax rate is 22 percent, and
we require a return of 10 percent 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
quantity sold? Explain what your answer tells you about a 500-unit decrease in the quantity sold.
 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.
6. Scenario Analysis [ LO2] 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.
7. Calculating Break-Even [ LO3] 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.

Unit Price Unit V ariable Cost Fixed Costs Depreciation Page 383

$2,980 $1,640 $7,200,000 $2,900,000

44 39 275,000 183,000

8 3 5,800 1,100

8. Calculating Break-Even [ LO3] In each of the following cases, find the unknown variable:

Accounting Unit V ariable

Break-Even Unit Price Cost Fixed Costs Depreciation

143,286 $39 $30 $ 820,000 ?

104,300 ? 27 2,320,000 $975,000

24,640 92 ? 237,000 128,700

9. Calculating Break-Even [ LO3] A project has the following estimated data: Price = $53 per unit;
variable costs = $22 per unit; fixed costs = $31,460; required return = 12 percent; initial investment
= $46,200; life = four years. Ignoring the effect of taxes, what is the accounting break-even quantity?
The cash break-even quantity? The financial break-even quantity? What is the degree of operating
leverage at the financial break-even level of output?
10. Using Break-Even Analysis [ LO3] Consider a project with the following data: Accounting break-
even quantity = 14,300 units; cash break-even quantity = 9,700 units; life = 5 years; fixed costs =
$205,000; variable costs = $19 per unit; required return = 12 percent. Ignoring the effect of taxes,
find the financial break-even quantity.
11. Calculating Operating Leverage [ LO4] At an output level of 40,000 units, you calculate that the
degree of operating leverage is 3.19. If output rises to 44,000 units, what will the percentage change
in operating cash flow be? Will the new level of operating leverage be higher or lower? Explain.
12. Leverage [ LO4] In the previous problem, suppose fixed costs are $183,000. What is the
operating cash flow at 38,000 units? The degree of operating leverage?
13. Operating Cash Flow and Leverage [ LO4] A proposed project has fixed costs of $76,000 per
year. The operating cash flow at 9,200 units is $108,700. Ignoring the effect of taxes, what is the
degree of operating leverage? If units sold rise from 9,200 to 10,000, what will be the increase in
operating cash flow? What is the new degree of operating leverage?
14. Cash Flow and Leverage [ LO4] At an output level of 14,500 units, you have calculated Page 384
that the degree of operating leverage is 3.41. The operating cash flow is $81,000 in this
case. Ignoring the effect of taxes, what are fixed costs? What will the operating cash flow be if
output rises to 15,500 units? If output falls to 13,500 units?
15. Leverage [ LO4] In the previous problem, what will be the new degree of operating leverage in
each case?

INTERMEDIATE
(Q uestions 16–24)
16. Break-Even Intuition [ LO3] Consider a project with a required return of R percent that costs $I
and will last for N years. The project uses straight-line depreciation to zero over the N-year life; there
is no salvage value or net working capital requirements.
a. At the accounting break-even level of output, what is the IRR of this project? The payback
period? The NPV?
b. At the cash break-even level of output, what is the IRR of this project? The payback period? The
NPV?
c. At the financial break-even level of output, what is the IRR of this project? The payback period?
The NPV?
17. Sensitivity Analysis [ LO1] Consider a four-year project with the following information:
Initial fixed asset investment = $655,000; straight-line depreciation to zero over the four-year life;
zero salvage value; price = $28; variable costs = $16; fixed costs = $245,000; quantity sold = 61,000
units; tax rate = 21 percent. How sensitive is OCF to changes in quantity sold?
18. Operating Leverage [ LO4] In the previous problem, what is the degree of operating leverage at
the given level of output? What is the degree of operating leverage at the accounting break-even
level of output?
19. Project Analysis [ LO1, 2, 3, 4] You are considering a new product launch. The project will cost
$1,675,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero.
Sales are projected at 195 units per year; price per unit will be $16,300, variable cost per unit will
be $9,400, and fixed costs will be $550,000 per year. The required return on the project is 12
percent, and the relevant tax rate is 21 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?
b. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.
c. What is the cash break-even level of output for this project (ignoring taxes)?
d. What is the accounting break-even level of output for this project? What is the degree of
operating leverage at the accounting break-even point? How do you interpret this number?
20. Project Analysis [ LO1, 2] McGilla Golf has decided to sell a new line of golf clubs. The clubs
will sell for $815 per set and have a variable cost of $365 per set. The company has spent $150,000
for a marketing study that determined the company will sell 55,000 sets per year for seven years.
 The marketing study also determined that the company will lose sales of 10,000 sets of its high-
priced clubs. The high-priced clubs sell at $1,345 and have variable costs of $730. The company will
also increase sales of its cheap clubs by 12,000 sets. The cheap clubs sell for $445 and have variable
costs of $210 per set. The fixed costs each year will be $9.45 million. The company has also spent
$1 million on research and development for the new clubs. The plant and equipment required will
cost $39.2 million and will be depreciated on a straight-line basis. The new clubs will also require
an increase in net working capital of $1.85 million that will be returned at the end of the project.
The tax rate is 25 percent, and the cost of capital is 10 percent. Calculate the payback period, the
NPV, and the IRR.

21. Scenario Analysis [ LO2] In the previous problem, you feel that the values are accurate Page 385
to within only ± 10 percent. What are the best-case and worst-case NPVs? H int: The price
and variable costs for the two existing sets of clubs are known with certainty; only the sales gained
or lost are uncertain.
22. Sensitivity Analysis [ LO1] In Problem 20, McGilla Golf would like to know the sensitivity of
NPV to changes in the price of the new clubs and the quantity of new clubs sold. What is the
sensitivity of the NPV to each of these variables?
23. Break-Even Analysis [ LO3] Hybrid cars are touted as a “green” alternative; however, the
financial aspects of hybrid ownership are not as clear. Consider the 2019 Toyota RAV4 Hybrid,
which had a list price of $5,900 (including tax consequences) more than the comparable gasoline-
only SUV. Additionally, the annual ownership costs (other than fuel) for the hybrid were expected
to be $250 more than the gasoline-only model. The EPA mileage estimate was 39 mpg for the
hybrid and 30 mpg for the gasoline-only SUV.
a. Assume that gasoline costs $2.85 per gallon and you plan to keep either car for six years. How
many miles per year would you need to drive to make the decision to buy the hybrid worthwhile,
ignoring the time value of money?
b. If you drive 15,000 miles per year and keep either car for six years, what price per gallon would
make the decision to buy the hybrid worthwhile, ignoring the time value of money?
c. Rework parts (a) and (b) assuming the appropriate interest rate is 10 percent and all cash flows
occur at the end of the year.
d. What assumption did the analysis in the previous parts make about the resale value of each car?
24. Break-Even Analysis [ LO3] In an effort to capture the large jet market, Airbus invested $13
billion developing its A380, which is capable of carrying 800 passengers. The plane had a list price
of $280 million. In discussing the plane, Airbus stated that the company would break even when
249 A380s were sold.
a. Assuming the break-even sales figure given is the accounting break-even, what is the cash flow
per plane?
b. Airbus promised its shareholders a 20 percent rate of return on the investment. If sales of the
plane continue in perpetuity, how many planes must the company sell per year to deliver on this
promise?
c. Suppose instead that the sales of the A380 last for only 10 years. How many planes must Airbus
sell per year to deliver the same rate of return?
CHALLENGE
(Q uestions 25–30)
25. Break-Even and Taxes [ LO3] This problem concerns the effect of taxes on the various break-even
measures.
a. Show that, when we consider taxes, the general relationship between operating cash flow, OCF,
and sales volume, Q, can be written as:

b. Use the expression in part (a) to find the cash, accounting, and financial break-even points for
the Wettway sailboat example in the chapter. Assume a 21 percent tax rate.
c. In part (b), the accounting break-even should be the same as before. Why? Verify this
algebraically.

26. Operating Leverage and Taxes [ LO4] Show that if we consider the effect of taxes, the Page 386
degree of operating leverage can be written as:

DOL = 1 + [ FC × (1 − TC) − TC × D] / OCF

Notice that this reduces to our previous result if TC = 0. Can you interpret this in words?
27. Scenario Analysis [ LO2] Consider a project to supply Detroit with 20,000 tons of machine
screws annually for automobile production. You will need an initial $3.1 million investment in
threading equipment to get the project started; the project will last for five years. The accounting
department estimates that annual fixed costs will be $925,000 and that variable costs should be
$185 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over
the five-year project life. It also estimates a salvage value of $400,000 after dismantling costs. The
marketing department estimates that the automakers will let the contract at a selling price of $295
per ton. The engineering department estimates you will need an initial net working capital
investment of $380,000. You require a return of 13 percent and face a tax rate of 22 percent on this
project.
a. What is the estimated OCF for this project? The NPV? Should you pursue this project?
b. Suppose you believe that the accounting department’s initial cost and salvage value projections
are accurate only to within ± 15 percent; the marketing department’s price estimate is accurate
only to within ± 10 percent; and the engineering department’s net working capital estimate is
accurate only to within ± 5 percent. What is your worst-case scenario for this project? Your best-
case scenario? Do you still want to pursue the project?
28. Sensitivity Analysis [ LO1] In Problem 27, suppose you’re confident about your own projections,
but you’re a little unsure about Detroit’s actual machine screw requirement. What is the sensitivity
of the project OCF to changes in the quantity supplied? What about the sensitivity of NPV to
changes in quantity supplied? Given the sensitivity number you calculated, is there some minimum
level of output below which you wouldn’t want to operate? Why?
29. Break-Even Analysis [ LO3] Use the results of Problem 25 to find the accounting, cash, and
financial break-even quantities for the company in Problem 27.
30. Operating Leverage [ LO4] Use the results of Problem 26 to find the degree of operating leverage
for the company in Problem 27 at the base-case output level of 20,000 tons. How does this number
compare to the sensitivity figure you found in Problem 28? Verify that either approach will give you
the same OCF figure at any new quantity level.