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 $ 50 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 operating next​ year, the extra capacity is expected to generate $ 10 million per year in additional​ sales, which will continue for the​ ten-year life of the machine. bullet ​Operations: The disruption caused by the installation will decrease sales by $ 5 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 70 % of their sale price. The increased production will also require increased inventory on hand of $ 1 million during the life of the project. The increased production will require additional inventory of $ 1 ​million, to be added in year 0 and depleted in year 10. bullet Human​ Resources: The expansion will require additional sales and administrative personnel at a cost of $ 2 million per year. bullet ​Accounting: The​ XC-750 will be depreciated via the​ straight-line method in years​ 1?10. Receivables are expected to be  15 % of revenues and payables to be 10 % of the cost of goods sold.​ Billingham?s marginal corporate tax rate is 15 %.

a. Determine the incremental earnings from the purchase of the​ XC-750.

b. Determine the free cash flow from the purchase of the​ XC-750.

c. If the appropriate cost of capital for the expansion is 10.0 %​, compute the NPV of the purchase.

d. While the expected new sales will be $ 10 million per year from the​ expansion, estimates range from $ 8 million to $ 12 million. What is the NPV in the worst​ case? In the best​ case?

e. What is the​ break-even level of new sales from the​ expansion? What is the​ break-even level for the cost of goods​ sold?

f. Billingham could instead purchase the​ XC-900, which offers even greater capacity. The cost of the​ XC-900 is $ 4 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. What level of additional sales​ (above the $ 10 million expected for the​ XC-750) per year in those years would justify purchasing the larger​ machine?

Answer 1

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