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Financial Break-Even Point

IRR ?
Payback Period ?
NPV ?

Financial Break-Even Point


(1)
Financial break-even occurs when the
NPV of the project is zero.
The financial break-even point is :
OCF = [(P VC) x Q FC D] + D
OCF = (P VC) x Q FC
OCF + FC = (P VC) x Q
QBEP = OCF*+ FC
P VC

Where OCF* is the level of OCF that results in a


zero NPV.
Cash Outflow = OCF x PV

(%,n)

The payback period must be less than the


length of the project. Since the discounted cash
flows are equal to the initial investment, the
undiscounted cash flows are greater than the
initial investment, so the payback must be less
than the project life.
A zero NPV
An IRR just equal to the required return.

The Cornchopper Company is considering the purchase of a new


harvester. Cornchopper has hired you to determine the break-even
purchase price in terms of present value of the harvester. This
break-even purchase price is the price at which the projects NPV
is zero. Base your analysis on the following facts:

The new harvester is not expected to affect revenues, but pretax


operating expenses will be reduced by $12,000 per year for ten years.
The old harvester is now 5 years old with 10 years of its scheduled life
remaining.
It was originally purchased for $50,000 and has been
depreciated by the straight-line method.
The old harvester can be sold for $18,000 today
The new harvester will be depreciated by the straight-line method over its
10-year life.
The corporate tax rate is 34 percent.
The projects required return is 15 percent.
The initial investment, the proceeds from selling the old harvester and any
resulting tax effects occur immediately. Capital gains or losses are taxed
at the corporate of 34 percent when they are realized.
All other cash flows occur at the year-end.
The market value of each harvester at the end of its economic life is zero.

The old harvester is now 5 years old with


10 years of its scheduled life remaining. It
was originally purchased for $50,000 and
has been depreciated by the straight-line
method.
The new harvester will be depreciated by
the straight-line method over its 10-year
life.

Depreciation and Book Value


Calculations
Old Equipment:
Depreciation = 50,000 0 = 3,333.33
15
Book Value = 50,000 (5)(3,333.33) =
33,333.33

New Equipment:
Depreciation = Price
0,1Pricenew
10

new

0 =

The old harvester can be sold for


$18,000 today.
SP = Selling Price (or Market Value)
BV = Book Value
1. If an asset is sold at book value then there is
no gain or loss on the sale, hence no tax effect.
The cash flow in the problem will be the entire
amount from the sale.
2. If an asset is sold for more than book value,
there is a gain on the sale and taxes must be
paid on the gain. This will reduce the cash flow
from the sale value by the amount of taxes paid.
3. If an asset is sold at a loss, there is a tax writeoff, which can be applied to gains in other
investments. Cash flow from the sale will be

(SP BV) = Gain on Sale


t(SP BV) = Taxes due or tax write-off
SP t(SP BV) = After-tax cash flow (aftertax salvage value)
After-tax salvage value = SP t(SP BV)
= $18,000 0,34($18,000 $33,333.33)
= $18,000 0,34(-$15,333.33)
= $18,000 + $5,213.33
= $23,213,33

Depreciation Tax Shield


Calculation
Old Equipment:
Depreciation = 50,000 0 = 3,333.33 x Tax rate
15
= 3,333.33 x 0,34 ...... (1)

New Equipment:
Depreciation = Price new 0 = 0,1Pricenew x Tax
rate
10
= 0,1Pricenew x 0,34.....(2)