Question

Billingham Packaging is considering expanding its production capacity by purchasing a new​ machine, the​ XC-750. The cost of the​ XC-750 is $ 2.71 million.​ Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $ 45 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 operational next​ year, the extra capacity is expected to generate $ 10.20 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 $ 4.94 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 71 % of their sale price. The increased production will also require increased inventory on hand of $ 1.08 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 $ 2.06 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 16 % of revenues and payables to be 11 % 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 9.7 % ​, compute the NPV of the purchase. d. While the expected new sales will be $ 10.20 million per year from the​ expansion, estimates range from $ 8.30 million to  $ 12.10 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 $ 3.94 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 $ 10.20 million expected for the​ XC-750) per year in those years would justify purchasing the larger​ machine? a. Determine the incremental earnings from the purchase of the​ XC-750. Calculate the incremental earnings from the purchase of the​ XC-750 below​ (with vs. without​ XC?750):  ​(Round to the nearest​ dollar.)

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 -$500,120

d]

NPV in the worst case is -$2,649,252

NPV in the best case is $1,649,011