4. Break-even analysis To be profitable, a firm has to recover its costs. These costs indude both its fixed and its variable costs. One way that a firm evaluates at what stage it would recover the invested costs is to calculate how many units or how much in dollar sales is necessary for the firm to earn a profit. Petrox Oil Company is considering a project that will have fixed costs of $12,000,000. The product will be sold for $32.50 per unit, and will incur a variable cost of $12.80 per unit. Given the cost structure of Petrox, it will have to sell project (QBE). units to break even on this Marketing sales director of Petrox Oil Company doesn't think that the market for the firm's goods is big enough to sell enough units to make the company's target operating prfit of $20,000,000. In fact, she believes that the firm will be able to sell only about 150,000 units. However, she also thinks the demand for Petrox's product is relatively inelastic, so the firm can increase the sale price. Assuming that Petrox can sell 150,000 units, what price must it set to meet the CFO's EBIT goal of $20,000,000 $226.13 per unit $260.05 per unit $237.44 per unit $282.66 per unit What affects the firm's operating break-even point? Several factors affect a firm's operating break-even point. Based on the scenarios described in the following table, indicate whether these factors would increase, decrease, or leave unchanged a firm's break-even quantity-assuming that only the listed factor changes and all other relevant factors remain constant No Increase Decrease Change The firm depreciates its fixed assets more quickly over a shorter life The yarin What affects the firm's operating break-even point? Several factors affect a firm's operating break-even point. Based on the scenarios described in the following table, indicate whether these factors would increase, decrease, or leave unchanged a firm's break-even quantity-assuming that only the listed factor changes and all other relevant factors remain constant. No Increase Decrease Change The firm depreciates its fixed assets more quickly over a shorter life. The variable cost per unit decreases. The amount of debt increases, causing the firm's total interest expense to increase. When a large percentage of a firm's costs are fixed, the firm is said to have a degree of operating leverage. Companies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear. Consider the following case: Red Snail Satellite Company is considering a project that will require $700,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 40%. Assuming that the project generates an expected EBIT (earnings before interest and taxes) of $150,000, then Red Snail's anticipated ROE (return on equity) for the project will be: 8.36% 12.86% 10.93% 13.50% In contrast, assume that the project's EBIT is only $45,000. When calculating the tax effects, assume that the entire Red Snail Satellite Company will earn a large, positive income this year. The resulting ROE will be Now consider the case of the Black Sheep Broadcasting Company: Black Sheep Broadcasting Company is considering implementing a project that is identical to that being evaluated by Red Snail-although Black Sheep wants to finance the $700,000.00 in additional assets using 50% equity and 50% debt capital. The interest rate on Black Sheep's new debt is expected to be 13%, and the project is forecasted to generate an EBIT of $150,000. As a result, the project is expected to generate a ROE of Now assume that Black Sheep finances the same project with 50% debt and 50% equity capital, but expects it to generate an EBIT of only $45,000. Further assume that the company as a whole will generate a large, positive income this year, such that any loss generated by the project (with its resulting tax saving) will be offset by the company's other (positive) income. Remember, the interest rate on Black Sheep's debt is 13%. Under these conditions, it is reasonable to expect that Black Sheep will generate a ROE of. -0.12% -0.1% -0.09% -0.13% Given the ROE-related findings above for both Red Snail and Black Sheep, answer the following question: The use of financial leverage a firm's expected ROE, the probability of a large loss, and consequently the risk borne by the firm's stockholders The greater a firm's chance of bankruptcy, the its optimal debt ratio will be manager is more likely to use deht in an effort than