Question

Our award-winning folding carton structural designers, working with the latest technologies, bring you innovative paperboard folding carton structures - alternatives that can address your unique goals and take your product packaging to the next level. Whether you know exactly how you want your folding carton structure to look, or you need a partner to generate unique concepts - we're with you. Our structural designers focus first on understanding the unique qualities of your product. Then they produce innovative structural concepts that help communicate value to the customers you are trying to reach. To help you evaluate new structural designs for folding cartons, the company is considering acquisition of new IntriCut® to expand its production capacity.

The cost of IntriCut® is $ 2.75 million. Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $ 50,000 feasibility study to analyze the decision to buy the IntriCut, resulting in the following estimates:

Marketing: Once the IntriCut is operational next year, the extra capacity is expected to generate $10 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 $ 5 million this year. As with APC's existing products, the cost of goods for the products produced by the IntriCut 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, including year 0.

Human Resources: The expansion will require additional sales and administrative personnel at a cost of $ 2 million per year.

Accounting: The IntriCut 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 10 % of the cost of goods sold. APC's marginal corporate tax rate is 35%.

a. Determine the incremental earnings from the purchase of the IntriCut.

b. Determine the free cash flow from the purchase of the IntriCut.

c. If the appropriate cost of capital for the expansion is 10 %, compute the NPV of the purchase.

d. While the expected new sales will be $ 10. million per year from the expansion, estimates range from $ 8.0 million to $ 12.0 million. What is the NPV in the worst case? In the best case?

Answer 1

Answer a:

All figures in dollar

Expected additional sale from installation of the machine		10000000
Cost of good sold each year (due to new machine)		7000000	70% of the sale price
HR related cost		2000000
Depreciation per year		275000	(cost of machine)/ 10
Earning before tax		725000	(sale - COGS - HR cost - Depreciation)
Corporate tax		253750	(Earning before tax * 35%)
Net Incremental Income (per year)		471250	(Earning before tax - Corporate tax)

Answer b:

Formula for free cash flow: EBIT - Taxes + Depreciation – Change in Working Capital

Free cash flow for year 1 (when the machine gets installed):

EBIT		725000
tax		-253750
Depreciation		275000
Change in Working Capital		0	as there is no change in Working Capital across various years
Free Cash Flow		746250	(Answer)

Answer c:

Initial cost for the new machine: Cost of the machine + Feasibility study cost =  $2.8 million

Cash flow for each of the 10 years = $746250

Cost of capital: 10%

NPV (using financial calculator): $1,785,383.20 (Answer)

Answer d:

best case scenario: Sales is $12 million

Expected additional sale from installation of the machine		12000000
Cost of good sold each year (due to new machine)		8400000	(70% of the Sales)
HR related cost		2000000
Depreciation per year		275000
Earning before tax		1325000
Corporate tax		463750
Net Incremental Income (per year)		861250
Cash Flow		1136250	(EBIT - tax + depreciation)

NPV: $4,181,764.37 (Answer)

Worst case scenario: sale is $8 million

Expected additional sale from installation of the machine		8000000
Cost of good sold each year (due to new machine)		5600000	(70% of the Sales)
HR related cost		2000000
Depreciation per year		275000
Earning before tax		125000
Corporate tax		43750
Net Incremental Income (per year)		81250
Cash Flow		356250	(EBIT - tax + depreciation)

NPV in worst case scenario: -$610,997.97 (Answer)