Assume a firm is considering a new project that requires an...

Name: Problem 7, Chapter 11: Fundamentals of Corporate Finance
Uploaded: 2021-03-21T20:59:38-08:00
Duration: 2 min 9 s
Channel: Kaylee Mcclellan
Description: Assume a firm is considering a new project that requires an initial investment and has equal sales and costs over its life. Will the project reach the accounting, cash, or financial break-even point first? Which will it reach next? Last? Will this ordering always apply?

Assume a firm is considering a new project that requires an initial investment and has equal sales and costs over its life. Will the project reach the accounting, cash, or financial break-even point first? Which will it reach next? Last? Will this ordering always apply?

Key Concepts

Depreciation

Depreciation is the systematic allocation of the cost of a long-term asset over its useful life. Although it reduces accounting profit, it does not affect cash flow, which is why there is often a disparity between the accounting and cash break-even points. Understanding depreciation is important for distinguishing between actual cash profitability and reported earnings.

Financial Break-even Point

The financial break-even point is achieved when the net present value of a project’s cash flows is zero, meaning that the inflows—after covering all cash expenses and accounting for the cost of capital—are sufficient to cover the initial investment. This measure integrates both the time value of money and financing considerations, generally requiring a higher sales level than the other break-even points.

Accounting Break-even Point

This is the sales level at which a firm’s reported earnings, after subtracting all expenses including depreciation, equal zero. It reflects the point at which total revenues match total accounting costs and is critical for understanding profitability from a traditional financial reporting perspective.

Cash Break-even Point

This concept refers to the level of sales at which the firm's cash inflows just cover its cash outflows. Unlike the accounting break-even point, the cash break-even excludes non-cash expenses such as depreciation and focuses solely on the actual cash generated by operations, often resulting in a lower threshold than the accounting break-even point.

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