Oleck Inc. produces stereo components that sell at P = $100 per unit. Olecks fixed costs are $200,000, variable costs are $50 per unit, 5,000 components are produced and sold each year, EBIT is currently $50,000, and Olecks assets (all equity-financed) are $500,000. Oleck can change its production process by adding $400,000 to assets and $50,000 to fixed operating costs. This change would (1) reduce variable costs per unit by $10 and (2) increase output by 2,000 units, but (3) the sales price on all units would have to be lowered to $95 to permit sales of the additional output. Oleck has tax loss carry-forwards that cause its tax rate to be zero, it uses no debt, and its average cost of capital is 10%.

Should Oleck make the change?

1) Determine the new EBIT level if the change is made: $

(2) Determine the incremental EBIT: $

(3) Estimate the approximate rate of return on the new investment: %

(4) Should make the change? (answer yes or no):

Would Olecks break-even point increase or decrease if it made the change? Calculate old and new break-even points

a) Old break-even point = units

b) New break-even point = units

c) Increase or decrease?

(2) Determine the incremental EBIT: $

(3) Estimate the approximate rate of return on the new investment: %

(4) Should make the change? (answer yes or no):

Suppose Oleck was unable to raise additional equity financing and had to borrow the $400,000 at an interest rate of 10% to make the investment. Use the DuPont equation to find the expected ROA of the investment. Calculate incremental ROA. Should Oleck make the change if debt financing must be used?

Answers:

a) Incremental ROA = %

b) Should make the change? (enter yes or no):