12-10 (35 marks)

Quantum Computers Inc. produces mini supercomputers that sell for $210,000 each. The firms fixed costs, F, are $5 million; 200 supercomputers are produced and sold each year; profits total $1.5 million, and the firms assets (all equity financed) are $10 million. The firm estimates it can change its production process, adding $4 million to investment and $3 million to fixed operating costs. This change will (1) reduce variable costs per unit by $20,000 and (2) increase output by 40 units, but (3) the sales price on all units will have to be lowered to $200,000 to permit sales of the additional output. The firm has tax loss carryforwards that cause its tax rate to be zero, its cost of equity is 16%, and it uses no debt.

a. What is the incremental profit? To get a rough idea of the projects profitability, what is the projects expected rate of return for the next year (defined as the incremental profit divided by the investment)? Should the firm make the investment?

b. Would the firms break-even point increase or decrease if it made the change?

c. Would the new situation expose the firm to more or less business risk than the old one?