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

$ 2.81 million.Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $47,000

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

$ 10.10 million per year in additional sales, which will continue for the10-year life of the machine.

Operations: The disruption caused by the installation will decrease sales by

$ 5.04 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

68 % 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.

Human Resources: The expansion will require additional sales and administrative personnel at a cost of

$ 1.99 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 9 % 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

10.1 % compute the NPV of the purchase.

d. While the expected new sales will be $ 10.10million per year from the expansion, estimates range from

$ 8.15 to $12.05 million. What is the NPV in the worstcase? 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 $ 3.94million. 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

$ 10.10 million expected for theXC-750) per year in those years would justify purchasing the larger machine?

Explanation / Answer

As feasibility cost cannot be recovered in future, it is sunk cost and needs to be ignored Purchase price of XC-750 = 2810000 Additional Sales 10100000 Period 10 Years Decrease in sales 5040000 Cost of goods sold 68% of sales Increase in inventory 10130000 Additional sales and admin personal 1990000 Life of Machine 10 Years Depreciation per year 281000 Accounts receivables 16% of revenues Accounts payables 9% of cost of goods Tax rate 35% Additional Sales 10100000 Cost of goods goods sold -6868000 Additional sale and admin personnal -1990000 Depreciation expense -281000 Incremental earnings before tax 961000 Tax expense -336350 Incremental earnings after tax 624650 Free Cash flow = operating cash flow - Capex - change in working capital Operating cash flow = EBIT * (1-t)+Depreciation Net Loss of due to lost sales needs to be calculated as follows Lost sales 5040000 Cost of goods sold -3427200 Income before tax 1612800 Tax Expense -564480 Net Income from lost sales 1048320 This income will be cost due to loss sales and hence it should also be considered opportunity cost Year 0 1 2 3 4 5 6 7 8 9 10 Incremental earnings after tax 624650 624650 624650 624650 624650 624650 624650 624650 624650 624650 Add depreciation 281000 281000 281000 281000 281000 281000 281000 281000 281000 281000 Operating Cash flow 905650 905650 905650 905650 905650 905650 905650 905650 905650 905650 Investment in machine -2810000 Loss in sales -1048320 Additional inventory 10130000 10130000 10130000 10130000 10130000 10130000 10130000 10130000 10130000 10130000 10130000 Accounts receivables 1616000 1616000 1616000 1616000 1616000 1616000 1616000 1616000 1616000 1616000 Accounts payables -618120 -618120 -618120 -618120 -618120 -618120 -618120 -618120 -618120 -618120 Net working capital 10130000 12364120 12364120 12364120 12364120 12364120 12364120 12364120 12364120 12364120 12364120 Change in working capital 2234120 0 0 0 0 0 0 0 0 0 Recovery of working capital 12364120 Free Cash flow -1.4E+07 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 Cost of Capital 10.10% Year 0 1 2 3 4 5 6 7 8 9 10 Free Cash flow -13988320 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 -9224350 Cost of Capital 10.10% -$7,04,25,285.09 Hence NPV is -$70425285.09

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