Profit for the firm
From a financial perspective, what metric(s) should be calculated and why? The main purpose of taking on a project is to generate profit for the firm. Therefore the core concern should be if this project will return a profit and when. The clearest way to identify the profit potential is to calculate the breakeven point; this is the point when the firm can expect to start earning a profit. Also in deciding to do this project calculating the various types of cash flow will be helpful in understanding how the project will progress.
The Breakeven is usually the single most important deciding factor in determining to implement a project. Shane is worried about product demand and is wondering about the minimum threshold for sales. What financial concept/approach/metric would assist Shane? If there are alternatives, compare them and identify the best among them. Calculating the minimum threshold for sales is the same as finding the breakeven point.
In this example there is enough information to find the breakeven point in three different ways; the Net Income (NI) method, the Net Present Value method (NPV), and setting up a spread sheet. Each will deliver a different answer; the Net Income is the least conservative option, meaning that it that it will deliver a lower breakeven point. While setting up a spreadsheet and using the goal seek function in Excel will produce a more accurate breakeven point, but will also result in a higher point which produces in a more conservative approach to choosing the project.
In the middle is the NPV method, this process is similar to the NI method but it factors in the Equivalent Annual Cost (EAC) which is the annual cost of owning the machinery. In this scenario setting up a spreadsheet and using the goal seek function in Excel is the best method. The spreadsheet is more accurate, all of the data is displayed and the project manager can foresee where problems may arise. For the approach you identified as the best, what are the required input, and formulas?
This project is scheduled to last 4 years and consequently there is a limited amount of data that is required to be inputted in to excel, all of the factors necessary to compute are known such as; expected units sold, the price and cost per unit, and the annual fixed costs associated with the project. With these inputs the required calculations can be made. The first part to setting up the spread sheet is to create a simple time table that list the years across and the factors of change in the left hand column.
That column needs to include; the initial investment, units sold, price per unit, cost per unit, the SAG per year, any deprecation, the tax rate and the discount rate. Then enter the information in the correct cells. The next step is to set up the table used to calculate the breakeven point. In this table the firs column will have an operating section and an investing section. The operating section will have the categories of; revenue, expenses, SGA, deprecation, earnings before tax, taxes, net income, then operational cash flow.
The numbers from the first table are used to find the answers in the second table. Implement the approach and interpret the answer. Discuss limitations of the approach. After calculating all three approaches the NI returned a value of 1785, the NPV returned a value of 2209 and the spread sheep method returned a value of 2297. With a breakeven point of 2297 and an expected sale of 2500 units per year, a difference of 203 units, the spreadsheet method predicts a net income of $42,666 beyond the breakeven point, and an after tax profit of $28,160 per year.
One of the limiting factors of this approach is that someone could get wrapped up in the details of the project and neglect to focus on the project as a whole. Also if the project goes on for many years entering the details in to the spread sheet could be tedious. This method only works if a lot of the details are known; if the unit price is undetermined or the cost per unit is unclear the spread sheet method fails.