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 $50,000 feasibility study to analyze the decision to buy the XC-750, resulting in the following estimates:

■ 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.

■ 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 $1M, to be added in year 0 and depleted in year 10.

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

■ 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. (NOPAT)

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%, 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?

NEED D, E, and F!! Show work.

Answer 1

		$50000 spent on feasibility study is a sunk cost and not relevant
	a	Incremental Earnings
		Year2-11
	A	Additional Sales per year	$10,000,000
	B=A*70%	Cost of goods (70%)	$7,000,000
	C	Incremental Sales & Admin Cost	$2,000,000
	D	Annual Depreciation=2.75 million/10	$275,000
	E=A-B-C-D	Before Tax Incremental Earnings year2-11	$725,000
	F=E*(1-0.15)	After Tax Incremental earning Year2-11	$616,250	(725000*(1-0.15)
		Year1
		Decrease in Sales	$5,000,000
		Cost of goods (70%)	$3,500,000
		Before Tax Incremental Earning Year1	($1,500,000)
		After Tax Incremental earning Year1	($1,275,000)	(-1500000*(1-0.15)
	b	Free Cash Flow:
		Year0
		Cost of machine	($2,750,000)
		Inventory	($1,000,000)
		Total Free Cash Flow in Year0	($3,750,000)
		Year1
		After Tax Incremental earning Year1	($1,275,000)
		Increase in receivables=15%*10million	-$1,500,000
		Increase in Payables=10%*7000000	$700,000
		Free Cash Flow- Year1	($2,075,000)
		Free Cash flowYear 2-10
		After Tax Incremental earning	$616,250
		Add:Depreciation	$275,000
		Free Cash Flow- Year2-10	$891,250
		Free Cash Flow in Year11
		After Tax Incremental earning	$616,250
		Add:Depreciation	$275,000
		Release of working capital (Inventory)	$1,000,000
		Release of working capital (Receivable& Payables)	$800,000	(1500000-700000)
		Free Cash Flow in Year11	$2,691,250
		C . CALCULATION OF NPV
		Present Value of Cash Flow=(Cash Flow)/((1+i)^N)
		i=discount rate=10%=0.1, N=Year of Cash flow
		N	FCF	PV=FCF/(1.1^N)
		Year	Free Cash Flow	Present Value
		0	($3,750,000)	($3,750,000)
		1	($2,075,000)	($1,886,364)
		2	$891,250	$736,570
		3	$891,250	$669,609
		4	$891,250	$608,736
		5	$891,250	$553,396
		6	$891,250	$503,087
		7	$891,250	$457,352
		8	$891,250	$415,775
		9	$891,250	$377,977
		10	$891,250	$343,615
		11	$2,691,250	$943,267
			SUM	($26,979)
		Net Present Value=NPV=Sum of PV	($26,979)

Release of working capital (Receivable& Payables) $800,000 Free Cash Flow in Year11 $3,201,250 NPV BEST CASE CALCULATION OF NPV FCF PV=FCF/(1.1^N) Year Free Cash Flow Present Value 0 ($3,750,000) ($3,750,000) 1 ($2,075,000) ($1,886,364) 2 $1,401,250 $1,158,058 3 $1,401,250 $1,052,780 4 $1,401,250 $957,073 5 $1,401,250 $870,066 6 $1,401,250 $790,969 $1,401,250 $719,063 8 $1,401,250 $653,693 9 $1,401,250 $59

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