1. Prepare a variable-costing income statement for the proposed plant.

Compute the ratio of net income to sales. Is Karl correct that the return on
sales is significantly lower than the company average?

• With above variable-costing income statement, fixed overhead is treated as an expense.

Since the computed ratio of net income to sales turned to be 3.24%, Karl is correct in
stating that the Return on Sales (ROS) is significantly lower than the company’s average
between 7.5 and 8.5%. This signifies that if the company would invest in the proposed
plant, it would earn less than 4.26 to 5.6% from the normal company’s sale average.
2. Compute the payback period for the proposed plant. Is Karl right
that the payback period is greater than 4 years? Explain. Suppose
you were told that the equipment being transferred from Wyoming
could be sold for its book value. Would this affect your answer?

 Karl is wrong. Book value of the equipment and the

furniture should not be included in the amount of the
original investment because there is no opportunity
cost associated with them. These items would only be
transferred from a plant that opened in another state,
Wyoming, during the oil boom period and closed a few
years. Excluding the book value reduces the
investment from $582,000 to $352,000. Karl’s payback
would be correct if the equipment and furniture could
be sold for their book value because there would now
be an opportunity cost associated with them and that
cost should be included in the original investment.
3. Compute the NPV and the IRR for the proposed plant. Would
your answer be affected if you were told that the furniture and
equipment could be sold for their book values? If so, repeat the
analysis with this effect considered.
 Given two different situations regarding equipment and
furniture, whether these can be sold for their book values
or would only be merely transferred from one plant to
another, will have a great impact on our decision making
process. If these items will only be transferred from an old
plant to the proposed plant, it would generate IRR between
25 to 30%. Since the cost of capital is 10%, we may
conclude that the proposed plant should be accepted
because IRR is greater than its cost of capital. This will
result to a positive Net Present Value (NPV, resulting to an
increase in firm’s wealth profitability. On the other hand, if
these items can be sold for its book value, from above’s
computation, its new IRR turns out to be between 12 to
14%. Still, our new IRR is greater than cost of capital of
10%. We may conclude the proposed plant’s inflow is
greater than our initial outlay. However, it resulted to a
lower amount of profitability when compared with
equipment and furnitures merely transferred from the old
plant.
4. Compute the cubic yards of cement that must be sold for the new plant to
break even. Using this break-even volume, compute the NPV and the IRR.
Would the investment be acceptable? If so, explain why an investment that
promises to do nothing more than break even can be viewed as acceptable.
 The investment is unacceptable. IRR is lower than its cost of
capital of 10% which results to a negative NPV. However, it
is also possible to have a positive NPV at the break-even
point. Breakeven is defined for accounting income, not for
cash flow. Since there are non cash expenses deducted from
revenues (ie. depreciation), accounting income understates
cash flow income. Zero income does not mean zero cash
inflows and vice versa. Suppose we have $ 100,000 as our
depreciation expense and everything remain constant, it
would result to a positive NPV of $ 262,457 cost of capital at
10%. Its IRR has been computed between 25 and 26% which
is greater than its  cost of capital at 10%. IRR = $352,000
(initial investment) / 100,000 (yearly cash flow which is
depreciation) = 3.52 (present value factor of annity).
5. Compute the volume of cement that must be sold for
the IRR to equal the firm’s cost of capital. Using this
volume, compute the firm’s expected annual income.
Explain this result.
 Cost of Capital = 10% for 10 years, so df
= 6.14457
An alternative solution is as follows:
 From above computation, we can conclude
selling 30,017 or 29,968 units (rounding off
difference) will result in Internal Rate of
Return (IRR = 28%) to equal with project’s
cost of capital (10%). At this rate,
company’s net income is close or at zero.
Once the company gets to sell more than
29,968 units, it is safe to say that for every
unit sold thereafter, they have covered for
their fixed costs and already earned net
income.