Question 12.1: Using Break-Even Numbers SITUATION: You have just finished c...
Using Break-Even Numbers
SITUATION: You have just finished calculating the pretax operating cash flow and accounting operating profit break-even numbers for the in-home computer-support business. These numbers are as follows:
• Pretax operating cash flow break-even point: 720 house calls per year (60 per month)
• Accounting operating profit break-even point: 960 house calls per year (80 per month)
You have also just heard that the national company that provides these services is going to move to the town in which you are located. This has caused you to reduce your estimate of the annual number of house calls you can expect for your business in half, from 1,440 (120 per month) to 720. How will this affect your decision to enter this business?
DECISION: With annual unit sales of 720, EBIT will be negative and EBITDA will equal $0. With EBITDA of $0, the business will not generate any cash flows that can be used to make necessary investments, let alone enable you to earn the opportunity cost of capital on the money you invest in this business. You can see this by referring back to the FCF calculation in Equation 11.2 or Exhibit 11.1. This is a case where you do not even need to calculate the NPV to know that it is negative.
FCF = [(Revenue – Op \ Ex – D\&A) \times (1 – t)] + D\&A – Cap \ Exp – Add \ WC 11.2
| Explanation | Calculation | Formula |
| The change in the firm’s cash income, excluding interest expense, resulting from the project
\left\{ \begin{matrix} \\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\ \end{matrix} \right.
|
Revenue | Revenue |
| \underline{-Cash \ operating \ expenses } | \underline{-Op \ Ex} | |
| Earnings before interest ,taxes, depreciation, and amortization | EBITDA | |
| \underline{-Depreciation \ and \ amortization } | \underline{-D\&A} | |
| Operating profit | EBIT | |
| \underline{\times (1-Firm’s marginal tax rate)} | \underline{\times (1-t)} | |
| Net operating profit after tax | NOPAT | |
| Adjustments for the impact of depreciation and amortization and investments on FCF.
\left\{ \begin{matrix} \\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\ \end{matrix} \right. |
\underline{+Depreciation \ and \ amortization } | \underline{+D\&A} |
| Cash flow from operations | CF Opns | |
| −Capital expenditures | −Cap Exp | |
| \underline{-Additions \ to \ working \ capital } | \underline{-Add \ WC} | |
| Free cash flow | FCF |