Question

Billingham Packaging is considering expanding its production capacity by purchasing a new​ machine, the​ XC-750. The cost of the​ XC-750 is $2.79 million.​ Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $46,000 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 $10.05 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 $4.96 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 69% of their sale price. The increased production will also require increased inventory on hand of $1.14 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 $1.95 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 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 $10.05 million per year from the​ expansion, estimates range from $8.10 million to $12.00 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 $4.05 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 $10.05 million expected for the​ XC-750) per year in those years would justify purchasing the larger​ machine?

Answer 1