Hobbiton Farm grows corn, which it sells for $4per bushel. Variable costs are$1 per bushel; fixed costs are $4.8 million. All costs and revenues are in cash. The only asset on Hobbitons balance sheet is land, which has both a book value and market value of $15 million. Hobbiton has no debt and a cost of equity capital of 12%. This represents a 4% risk-free interest rate plus an 8% premium that investors expect in exchange for bearing the risk of the investment. All earnings are distributed to the owners in the form of dividends. There are no income taxes.

Part I:

a. What is Hobbitons break-even point?

b. Suppose Hobbitons produces and sells 2.5 million bushels of corn. Find Hobbitons accounting income, return on equity (ROE), and residual income.

Is Hobbitons doing better, worse, or about the same as expected?

Part II:

Hobbiton is considering buying a wheat field. The land would cost $5 million and generate annual cash flow and accounting income of $700,000.

a. Given Hobbiton still produces and sells 2.5 million bushels of corn on its existing farm, what happens to Hobbitons ROE and residual income if it purchases the wheat field?

b. Is the investment a good idea? Why or why not?