You work in the Finance Division of a medium size company that is considering a project to supply a customer with 50,000 widgets annually. You will need an initial investment of $4,000,000 in new equipment to get the project started and you estimate that this project will remain active for five years.

The Accounting Department estimated $1,000,000 in annual fixed costs and a variable costs of $200 per unit. Additionally, they told you they will depreciate the initial fixed asset investment straight-line to zero over the five-year project life. Additionally, they are expecting a salvage value of $500,000 after dismantling costs.

The Marketing Department is confident that they will be able to negotiate a contract with the customer to pay $300 per unit. Finally, the Engineering Department informed that they will need an initial net working capital investment of $350,000.

You require a return of 15 percent and face a marginal tax rate of 40 percent on this project.

1) Suppose youre confident about your own projections, but youre not sure if your customer really needs the 50,000 widgets annually.

A) What is the sensitivity of the project OCF to changes in the quantity supplied?

B) What about the sensitivity of NPV to changes in quantity supplied?

C) Given the sensitivity number you calculated, is there some minimum level of output below which you wouldnt want to operate? Why?

D) Find the degree of operating leverage for the company using the base case of 50,000 widgets. How does this number compare to the sensitivity figure from 3? Check that either approach will give you the same OCF figure at a new quantity level. You can use the following formula to compute the degree of operating leverage:

DOL = 1 + [FC (1 T) T D]/OCF