Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows. The
danger is greatest with a new product because the cash flows are probably harder to predict.
With a sensitivity analysis, one variable is examined over a broad range of values. With a
scenario analysis, all variables are examined for a limited range of values.
It is true that if average revenue is less than average cost, the firm is losing money. This much of the
statement is therefore correct. At the margin, however, accepting a project with marginal revenue in
excess of its marginal cost clearly acts to increase operating cash flow.
It makes wages and salaries a fixed cost, driving up operating leverage.
Fixed costs are relatively high because airlines are relatively capital intensive (and airplanes
are expensive). Skilled employees such as pilots and mechanics mean relatively high wages
which, because of union agreements, are relatively fixed. Maintenance expenses are
significant and relatively fixed as well.
From the shareholder perspective, the financial break-even point is the most important. A
project can exceed the accounting and cash break-even points but still be below the financial
break-even point. This causes a reduction in shareholder (your) wealth.
The project will reach the cash break-even first, the accounting break-even next and finally
the financial break-even. For a project with an initial investment and sales after, this
ordering will always apply. The cash break-even is achieved first since it excludes
depreciation. The accounting break-even is next since it includes depreciation. Finally, the
financial break-even, which includes the time value of money, is achieved.
Soft capital rationing implies that the firm as a whole isn’t short of capital, but the division
or project does not have the necessary capital. The implication is that the firm is passing up
positive NPV projects. With hard capital rationing the firm is unable to raise capital for a
project under any circumstances. Probably the most common reason for hard capital
rationing is financial distress, meaning bankruptcy is a possibility.
The implication is that they will face hard capital rationing.
Solutions to Questions and Problems
Total variable costs = $0.74 + 2.61 = $3.35
Total costs = variable costs + fixed costs = $3.35(300,000) + $610,000 = $1,615,000
= $610,000 / ($7.00 – 3.35) = 167,123 units
= ($610,000 + 150,000) / ($7.00 – 3.35) = 208,219 units
Total costs = ($10.94 + 32)(140,000) + $800,000 = $6,811,600
Marginal cost = cost of producing one more unit = $42.94
Average cost = total cost/total quantity = $6,811,600/140,000 = $48.65
Minimum acceptable total revenue = 10,000($42.94) = $429,400.
Additional units should be produced only if the cost of producing those units can be recovered.