Question

Billingham Packaging is considering expanding its production capacity by purchasing a new? machine, the? XC-750. The cost of the? XC-750 is $2.75

million.? Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $49,000

feasibility study to analyze the decision to buy the? XC-750, resulting in the following? estimates:

• ?Marketing: Once the? XC-750 is operational next? year, the extra capacity is expected to generate $10.20 million per year in additional? sales, which will continue for the? 10-year life of the machine.

•?Operations: The disruption caused by the installation will decrease sales by $4.96 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 69% of their sale price. Theincreased production will also require increased inventory on hand of $1.03million during the life of the? project, including year 0.

•Human? Resources: The expansion will require additional sales and administrative personnel at a cost of $1.95 million per year.

•?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 16% 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 $4.01 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????(Select all the choices that? apply.)

A.The expansion will require additional sales and administrative personnel.

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

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

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

b. If Billingham knows that it can sell the? XC-750 to another firm for $2.19 million in two? years, what kind of real option would that? provide?

Answer 1

a) The real option XC- 900 machine provides to Billingham is that

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

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

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

b) If Billingham knows that it can sell the XC-750 to another firm for $ 2.19 million in two years, this would give him the option to abandon the investment.