Question

Billingham Packaging is considering expanding its production capacity by purchasing a new​ machine, the​ XC-750. The cost of the​ XC-750 is $ 2.76 million.​ Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $ 45,000 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 68 % of their sale price. The increased production will also require increased inventory on hand of $ 1.11 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 $ 2.09 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 14 % of revenues and payables to be 10 % of the cost of goods sold.​ Billingham's marginal corporate tax rate is 35 %.

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 9.8%​, compute the NPV of the purchase.

d. While the expected new sales will be $10.00 million per year from the​ expansion, estimates range from $7.95 million to $12.05 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 breakeven 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 $4.09 million. The extra capacity would not be useful in the first two years of​ operation, but would allow for additional sales in years 3 through 10. What level of additional sales​ (above the $10.00 million expected for the​ XC-750) per year in those years would justify purchasing the larger​ machine?

Incremental Effects
Year		0
Sales Revenues	$
Cost of Goods Sold	$
S, G, and A Expenses	$
Depreciation	$
EBIT	$
Taxes at 35%	$
Unlevered Net Income	$

Answer 1

a). Incremental earnings:

Year 0: -1,042,080

Year 1 -10: 542,100

b). Free cash flow:

Year 0: -4,551,360

Year 1: -262,620

Year 2-10: 818,100

Year 11: 720,000

c). NPV of the purchase = 228,000.22

Calculations in the table below:

d). Using the base-case valuation table given above and changing the sales numbers, the best case and worst case NPV's are calculated to be:

Worst-case sale of 7,950,000 - NPV = -2,333,058.82

Best-case sale of 12,050,000 - NPV = 2,789,059.25