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 $49,000 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 $10.00 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 $ 5.05 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 73% 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.

Human​ Resources: The expansion will require additional sales and administrative personnel at a cost of $1.92 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 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 9.9%​, 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 $4.07 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?

Answer 1

Incremental Earnings from purchase of XC-750
	0	1	2	3	4	5	6	7	8	9	10
Revenue	-5050000	10000000	10000000	10000000	10000000	10000000	10000000	10000000	10000000	10000000	10000000
Cost of Goods Sold	3686500	-7300000	-7300000	-7300000	-7300000	-7300000	-7300000	-7300000	-7300000	-7300000	-7300000
Sales & Admin Expenses		-1920000	-1920000	-1920000	-1920000	-1920000	-1920000	-1920000	-1920000	-1920000	-1920000
Depreciation		-271000	-271000	-271000	-271000	-271000	-271000	-271000	-271000	-271000	-271000
EBIT	-1363500	509000	509000	509000	509000	509000	509000	509000	509000	509000	509000
Taxes	477225	-178150	-178150	-178150	-178150	-178150	-178150	-178150	-178150	-178150	-178150
Net income	-886275	330850	330850	330850	330850	330850	330850	330850	330850	330850	330850

Free Cash Flow from Purchase of Machine												Year 11
Add: Depreciation		1920000	1920000	1920000	1920000	1920000	1920000	1920000	1920000	1920000	1920000
Less: Capital expenditures	-2710000	0	0	0	0	0	0	0	0	0	0
Less: Changes in Working Capital (Yn - Yn-1)	-660650	-1309350	0	0	0	0	0	0	0	0	0	1970000
Free Cash Flow (Part B)	-4256925	941500	2250850	2250850	2250850	2250850	2250850	2250850	2250850	2250850	2250850	1970000
NPV @ 9.99% (Part C)	$ 90,80,254.70
Changes in net working capital over the years
[Working Notes]	0	1	2	3	4	5	6	7	8	9	10	11
Receivables	-808000	1600000	1600000	1600000	1600000	1600000	1600000	1600000	1600000	1600000	1600000
Payables	368650	-730000	-730000	-730000	-730000	-730000	-730000	-730000	-730000	-730000	-730000
Inventory	1100000	1100000	1100000	1100000	1100000	1100000	1100000	1100000	1100000	1100000	1100000
Working Capital	660650	1970000	1970000	1970000	1970000	1970000	1970000	1970000	1970000	1970000	1970000
Changes in net working capital over the years	660650	1309350	0	0	0	0	0	0	0	0	0

NPV at different estimates	7950000	8360000	8770000	9180000	9590000	10000000	10410000	10820000	11230000	11640000	12050000
NPV (Part D)	7019734.07	7390627.78	7813035	8235441	8657848	9080255	9502661	9925068	10347475	10769882	11192288