Billingham Packaging is considering expanding its production capacity by purchas
ID: 2614723 • Letter: B
Question
Billingham Packaging is considering expanding its production capacity by purchasing a new? machine, the? XC-750. The cost of the? XC-750 is $2.77 million.? Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $48,000 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 $10.10 million per year in additional? sales, which will continue for the? ten-year life of the machine. bullet• ?Operations: The disruption caused by the installation will decrease sales by $4.98 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
$1.03 million during the life of the? project, including year 0 and depleted in year 10.
*Human? Resources: The expansion will require additional sales and administrative personnel at a cost of $1.93 million per year.
*Accounting: The? XC-750 will be depreciated via the? straight-line method over the? ten-year life of the machine. The firm expects receivables from the new sales to be
15% 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 10.3%?, 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 $8.20 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? If the firm believes that sales will not? increase, but costs would be reduced by purchasing the new? machine, what is the? break-even 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 $4.08 million. The extra capacity would not be useful in the first two years of? operation, but would allow for additional sales in years? 3-10. 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?
Explanation / Answer
a Incremental earnings from the purchase of the XC-750. A Increase in Sales Revenue per year $10,100,000 B=0.69*A Increase in Cost of goods sold ($6,969,000) C Increase inSales and administrative costs ($1,930,000) D=A+B+C Incremental earnings from Year 2 onwards(Before tax) $1,201,000 E=D*(1-0.35) After tax increamental earning year 2 onwards $780,650 F Reduction in Sales Revenue in year1 ($4,980,000) G=0.69*F Decrease in Cost of goods sold $3,436,200 H Increase inSales and administrative costs ($1,930,000) I=F+G+H Increamental earning in year1(Before Tax) ($3,473,800) J=-I*0.35 Saving in tax $ 1,215,830 K=I+J After tax incremental earning in year1 ($2,257,970) Cash flow due to working Capital change: L Cash flow due to Increase in inventory year 0 ($1,030,000) M Cash flow due to Release of inventory in year10 $1,030,000 P=-0.15*F Cash flow due to change in receivable in year1 $747,000 Q=-0.15*A Cash flow due to change in receivable in year2 ($1,515,000) R=-0.1*G Cash flow due to change of payable in Year1 ($343,620) S=-0.1*B Cash flow due to change of payable in Year2 $696,900 T=P+R Net cash flow due to change in receivable and payable in year1 $403,380 U=Q+S Net cash flow due to change in receivable and payable in year2 ($818,100) Depreciation Tax shield: V=$2.77million/10 Annual Depreciation $ 277,000 W=V*0.35 Depreciation Tax shield: $ 96,950 Cost of Feasibility study ($48,000) is sunk cost. Not to be considered FREE CASH FLOW: N YEAR 0 1 2 3 4 5 6 7 8 9 10 Initial Investment ($2,770,000) After tax incremental earning in year1 ($2,257,970) After tax increamental earning year 2 onwards $780,650 $780,650 $780,650 $780,650 $780,650 $780,650 $780,650 $780,650 $780,650 Cash flow due to Increase in inventory year 0 to 9 ($1,030,000) $1,030,000 Net cash flow due to change in receivable and payable $403,380 ($818,100) $818,100 Depreciation Tax shield: $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 X YEAR WISE FREE CASH FLOW: ($3,800,000) ($1,757,640) $59,500 $877,600 $877,600 $877,600 $877,600 $877,600 $877,600 $877,600 $2,725,700 SUM PV=X/(1.103^N) Present Value (PV) at discount rate=cost of capital=10.3%=0.103 ($3,800,000) $ (1,593,509) $ 48,906 $ 653,988 $ 592,918 $ 537,550 $ 487,353 $ 441,843 $ 400,583 $ 363,176 $ 1,022,640 $ (844,550) NPV Net Present value (NPV) =Sum of PV of Free Cash Flows $ (844,550) d If Estimated Sales increase is $8.2 million, NPV at the worst a Incremental earnings from the purchase of the XC-750. A Increase in Sales Revenue per year $8,200,000 B=0.69*A Increase in Cost of goods sold ($5,658,000) C Increase inSales and administrative costs ($1,930,000) D=A+B+C Incremental earnings from Year 2 onwards(Before tax) $612,000 E=D*(1-0.35) After tax increamental earning year 2 onwards $397,800 F Reduction in Sales Revenue in year1 ($4,980,000) G=0.69*F Decrease in Cost of goods sold $3,436,200 H Increase inSales and administrative costs ($1,930,000) I=F+G+H Increamental earning in year1(Before Tax) ($3,473,800) J=-I*0.35 Saving in tax $ 1,215,830 K=I+J After tax incremental earning in year1 ($2,257,970) Cash flow due to working Capital change: L Cash flow due to Increase in inventory year 0 ($1,030,000) M Cash flow due to Release of inventory in year10 $1,030,000 P=-0.15*F Cash flow due to change in receivable in year1 $747,000 Q=-0.15*A Cash flow due to change in receivable in year2 ($1,230,000) R=-0.1*G Cash flow due to change of payable in Year1 ($343,620) S=-0.1*B Cash flow due to change of payable in Year2 $565,800 T=P+R Net cash flow due to change in receivable and payable in year1 $403,380 U=Q+S Net cash flow due to change in receivable and payable in year2 ($664,200) Depreciation Tax shield: V=$2.77million/10 Annual Depreciation $ 277,000 W=V*0.35 Depreciation Tax shield: $ 96,950 Cost of Feasibility study ($48,000) is sunk cost. Not to be considered FREE CASH FLOW: N YEAR 0 1 2 3 4 5 6 7 8 9 10 Initial Investment ($2,770,000) After tax incremental earning in year1 ($2,257,970) After tax increamental earning year 2 onwards $397,800 $397,800 $397,800 $397,800 $397,800 $397,800 $397,800 $397,800 $397,800 Cash flow due to Increase in inventory year 0 to 9 ($1,030,000) $1,030,000 Net cash flow due to change in receivable and payable $403,380 ($664,200) $664,200 Depreciation Tax shield: $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 $ 96,950 X YEAR WISE FREE CASH FLOW: ($3,800,000) ($1,757,640) ($169,450) $494,750 $494,750 $494,750 $494,750 $494,750 $494,750 $494,750 $2,188,950 SUM PV=X/(1.103^N) Present Value (PV) at discount rate=cost of capital=10.3%=0.103 ($3,800,000) $ (1,593,509) ######### $ 368,688 $ 334,259 $ 303,046 $ 274,747 $ 249,091 $ 225,830 $ 204,742 $ 821,260 ########## NPV Net Present value (NPV) =Sum of PV of Free Cash Flows $ (2,751,127)
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