A company produces some expensive widgets each selling for $200,000 each. The firm's fixed costs, F, are $2.5 million, 35 widgets are produced and sold each year, profits total $750,000, and the firm's assets (all equity financed) are $6 million. The firm estimates that it can change its production process, adding $3 million to investment and $600,000 to fixed operating costs. This change will: (1) reduce variable costs per unit by $8,000 and (2) increase output by 15 units, but (3) the sales price on all units will have to be lowered to $175,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 14%, and it uses no debt.
a. What is the incremental profit?
b. What is the project's expected rate of return for the next year (defined as the incremental profit divided by the investment)?
c. Should the firm make the investment? Why or why not?
d. Would the firm's break-even point increase or decrease if it made the change?