Josie Smith has decided to proceed with the new purifying and bottling project that you recently evaluated. Your analysis has given her greater confidence in the viability of the project. Ms. Smith must now decide whether to proceed with the initial structure of the project, or utilize one that has lower per unit operating costs but higher fixed operating costs. These options are detailed below.
The first option is to use the machinery identified in your original analysis. Ms. Smith is confident in the point estimate for variable cost per unit from this original analysis. This option is referred to as Plan A. A second alternative, Plan B, would have higher fixed costs of $550,000 per year and a lower cost per unit of $25.
Ms. Smith recalls something about business risk from a seminar she attended years ago, but she is uncertain of the proper analysis to conduct. Thus, she has once again hired you to consult with her on this project. In order to have a more refined distribution of units sold, Ms. Smith had her marketing department utilize an economic survey service. The results of their analysis is:
Economic State Probability Units
Hyper Growth 0.05 27,000
Growth 0.20 26,000
Average 0.40 22,000
Slow 0.25 19,000
Recession 0.10 18,000
For simplicity, the marketing department assumed that five possible states of the economy could occur. In your analysis, you should focus on the year one estimates for prices and costs in order to complete your study. The expected selling price nor the units sold depend on the production process chosen.
Note two unique issues. First, cannibalization has a significant impact on net sales and must be included in this analysis. The cannibalization effect represents, in essence, a fixed cost which must be accounted for in any breakeven analysis (even though it is not actually a fixed operating cost). Second, while depreciation does provide tax relief in the early life of the project, you should not include depreciation in this analysis. Calculate operating and net income as if depreciation did not exist.
In addition to the business risk analysis, Ms. Smith wants you to provide insight into the effect of using debt would have on the production process she chooses. Also, the company’s accountant was curious about various aspects of the two projects and wishes for you to provide further information concerning his questions. Below is a list of questions Ms. Smith (and the accountant) would like for you to address.
1. Which plan, A or B, do you recommend and why?
2. Now, regardless of your recommendations in question 5, assume that Ms. Smith decides to use Plan B. She is considering two possible financing alternatives. The first would involve no debt and financing would be provided by Mr. Smith in the form of equity. The second alternative would be 40% debt as in Case 1. The cost of debt is also in Case 1. Calculate the expected units sold, expected EBIT, DOL, DFL, DCL, and break-even (with cannibalization included) for each financing alternative (at the expected units) and discuss what this number means.