Question

Billingham Packaging is considering expanding its production capacity by purchasing a new​ machine, the​ XC-750. The cost of the​ XC-750 is $2.83 million.​ Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $47,000 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 $10.10 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 $4.93 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 72% of their sale price. The increased production will also require increased inventory on hand of $1.18 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 $2.05 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 10% of the cost of goods sold.​ Billingham's marginal corporate tax rate is 21%.

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 9.6%​, compute the NPV of the purchase.

d. While the expected new sales will be $10.10 million per year from the​ expansion, estimates range from $8.05 million to $12.15 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 $4.02 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 $10.10 million expected for the​ XC-750) per year in those years would justify purchasing the larger​ machine?

Answer 1

a]

incremental earnings before tax = additional sales - cost of goods sold - additional costs - depreciation

incremental earnings after tax = incremental earnings before tax - taxes

b]

Operating cash flow (FCF) each year = incremental income after tax + depreciation

FCF in year 0 = -(cost of machine + increase in inventory + incremental income after tax)

Decrease in contribution in year 0 =   decreased sales * (1 – cost of goods %)

The amount spent on feasibility study is a sunk cost as it is incurred in the past, and cannot be recovered. It should not be considered in the incremental cash flow analysis.

FCF in year 2 = OCF – increase in NWC (net working capital)

Increase in NWC = increase in accounts receivable – increase in accounts payable

FCF in years 2 to 9 = OCF

FCF in year 10 = OCF + terminal cash flow

Terminal cash flow = recovery of inventory + recovery of NWC

c]

NPV is calculated using NPV function in Excel

NPV is -$376,740

d]

NPV in the worst case is -$3,219,313

NPV in the best case is $2,465,833