Finance Problem 6-1 and 6-2

| June 6, 2016

Question
Problem 6-1

GBK, Inc. is considering a new product. The proposal is as follows:
Project cost: $2,000,000
Project life: 5 yrs
Salvage value: zero
Depreciation: straight line to zero
Sales projection: 180 units per year
Price per unit: $20,000
Variable cost per unit will be: $12,400
Fixed costs per year: $490,000
Required return on the project: 10%
Relevant tax rate: 35%
Based on our past experience, the unit sales, variable costs and fixed cost projections are probably accurate to within plus or minus 10%

A] What are the upper and lower bounds for these projections?

B] What is the base case NPV?

C] What are the best case NPV and the worst case NPV scenarios?

D] Evaluate the sensitivity of your base-case NPV to changes in fixed costs.

E] What is the cash break-even level of output for this project (ignoring taxes)?

F] What is the accounting break-even level of output for this project? What is the degree of operating leverage at the accounting break-even point? How do you interpret this number?

Problem 6-2

You purchased one GBK, Inc. 6 percent coupon bond one year ago for $1,020. The bond makes annual payments and matures four years from now. You sell the bond today when the required return is 5 percent. The inflation rate was 2.8 percent over the past year. What was the real return on your investment?

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