Billingham Packaging is considering expanding its production capacity by purchas

Question

Billingham Packaging is considering expanding its production capacity by purchasing a new machine, the XC-750. The cost of the XC-750 is $2.67 million Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $50,000 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 $4.97 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 75% 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 15% of revenues and payables to be 10% of the cost of goods sold. Billingham's marginal corporate tax rate is 35% 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 3-10 a. What kind of real option does the XC-900 machine provide to Billingham? a. What kind of real option does the XC-900 machine provide to Billingham? (Select all the choices that apply.) A. If it would be better if production remains the same. Billingham is under no obligation to utilize all of the XC-900 production capacity B. The XC-900 allows Billingham the option to expand production starting in year 3 C. If it would be beneficial to expand production. Billingham will increase production with the XC-900 D. The expansion will require additional sales and administrative personnel

Explanation / Answer

X-750 machine Initial costs: Cost of machine $2,670,000 Feasibility study $50,000 Increase in inventory $1,100,000 Total initial cash outflow $3,820,000 Decrease in sales in year1 $4,970,000 Decrease inCost of goods in year1 $3,727,500 (75% of decrease in sales)(0.75*4970000) Loss of profit in year1 $1,242,500 Additional cost of human resourses $1,920,000 Additional cash outflow in year 1 $3,162,500 (1242500+1920000) Additional sales in year2 to 10 $10,050,000 Additional costs of goods in year2 to 10 $7,537,500 (0.75*10050000) Increase in profit in year 2 to 10 $2,512,500 Additional human resources year2 to 10 $1,920,000 Net additional income $592,500 Taxes(35%) $207,375 After tax increase in income $385,125 Increase in accounts receivable in year1 $1,507,500 (0.15*10050000) Increase in accounts payable in year1 $753,750 (0.10*7537500) Net increase in working capital in year 1 $753,750 Net cash outflow in year1 $3,916,250 (3162500+753750) Annual Depreciation $267,000 (2670000/10) Annual Depreciation tax shield year1 to 10 $93,450.00 (267000*0.35) TERMINAL CASH FLOW Release of excess inventory $1,100,000 Release of additional working capital $753,750 Total terminal cash inflow $1,853,750 Present Value (PV) of Cash flow=(Cash flow)/((1+i)^N) i=discount rate, N=year of cash flow Discount rate is not provided Hence this option cannot be further analysed The option provided by X-900: If it would be beneficial to expand productionBillingham will increase production with XC-900

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