Question

Billingham Packaging is considering expanding its production capacity by purchasing a new​ machine, the​ XC-750. The cost of the​ XC-750 is $ 2.79 million.​ Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $ 49 comma 000 feasibility study to analyze the decision to buy the​ XC-750, resulting in the following​ estimates: bullet ​Marketing: Once the​ XC-750 is operational next​ year, the extra capacity is expected to generate $ 10.00 million per year in additional​ sales, which will continue for the​ 10-year life of the machine. bullet ​Operations: The disruption caused by the installation will decrease sales by $ 5.01 million this year. As with​ Billingham's existing​ products, the cost of goods for the products produced by the​ XC-750 is expected to be 72 % of their sale price. The increased production will also require increased inventory on hand of $ 1.18 million during the life of the​ project, including year 0. bullet Human​ Resources: The expansion will require additional sales and administrative personnel at a cost of $ 2.01 million per year. bullet ​Accounting: The​ XC-750 will be depreciated via the​ straight-line method over the​ 10-year life of the machine. The firm expects receivables from the new sales to be 15 % of revenues and payables to be 9 % of the cost of goods sold.​ Billingham's marginal corporate tax rate is 35 %. Billingham could instead purchase the​ XC-900, which offers even greater capacity. The cost of the​ XC-900 is $ 3.97 million. The extra capacity would not be useful in the first two years of​ operation, but would allow for additional sales in years​ 3-10.

a. What kind of real option does the​ XC-900 machine provide to​ Billingham?

b. If Billingham knows that it can sell the​ XC-750 to another firm for $ 2.15 million in two​ years, what kind of real option would that​ provide?

. What kind of real option does the​ XC-900 machine provide to​ Billingham?  ​(Select all the choices that​ apply.)

A.

The​ XC-900 allows Billingham the option to expand production starting in year 3.

B.

If it would be beneficial to expand​ production, Billingham will increase production with the​ XC-900.

C.

The expansion will require additional sales and administrative personnel.

D.

If it would be better if production remains the​ same, Billingham is under no obligation to utilize all of the​ XC-900 production capacity.

b. If Billingham knows that it can sell the​ XC-750 to another firm for

$ 2.15$2.15

million in two​ years, what kind of real option would that​ provide?  ​(Select the best​ choice.)

A.

This provides Billingham the option to abandon the investment.

B.

Billingham will no longer depreciate the machine.

C.

The firm can recover the feasibility study cost.

D.

The decreased production will also require decreased inventory.

Answer 1

What kind of real option does the​ XC-900 machine provide to​ Billingham?

A.The​ XC-900 allows Billingham the option to expand production starting in year 3.

Since XC-900 has higher capacity and it is expected that higher capacity will be required in year3 to 10, Purchasing XC-900 will allow Billingham the option to expand capacity in year3.

b. If Billingham knows that it can sell the​ XC-750 to another firm for $ 2.15 million in two​ years, what kind of real option would that​ provide?

A.This provides Billingham the option to abandon the investment.

The firm can go ahead and purchase XC-750 now. It will have option to abandon the investment at the end of year 2 and Purchase XC-900 which has higher capacity.