QUESTION 5

Sandro Aero Inc. produces satellite earth stations that sells for RMIOO,OOO each. The firm's fixed cost are RM2 million, 50 earth stations are produced and sold each year, profits total RM500,000 and the firm's assets (all equity financed) are RMS million.

The firm estimates that it can change its production process, adding RM4 million to investment and RM500,000 to fixed operating costs. This change will:

i) reduce variable cost per unit by RMIO,OOO ii) increase output by 20 units iii) the sales price on all units will have to be lowered to RM95,000.

The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 16% and uses no debt.

a) What is the incremental profit? What is the project's expected return next year? Should the firm make the investment?

(7 marks) b) Would the firm break-even point increase or decrease if it made the change?

(4 marks) c) Would the new situation expose the firm to more or less business risk than the old one?