Billingham Packaging is considering expanding its production capacity by purchasing a new machine, the XC-750. The cost of the XC-750 is $2.73 million. Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $45,000 feasibility study to analyze the decision to buy the XC-750, resulting in the following estimates: • Marketing: Once the XC-750 is operating next year, the extra capacity is expected to generate $10 million per year in additional sales, which will continue for the ten-year life of the machine. • Operations: The disruption caused by the installation will decrease sales by $4.91 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 $1.18 million during the life of the project. The increased production will require additional inventory of $1.18 million, to be added in year 0 and depleted in year 10. • Human Resources: The expansion will require additional sales and administrative personnel at a cost of $2 million per year. • Accounting: The XC-750 will be depreciated via the straight-line method in years 1-10. Receivables are expected to be 16% of revenues and payables to be 10% of the cost of goods sold. Billingham's marginal corporate tax rate is 15%. b. Determine the free cash flow from the purchase of the XC-750. a. Determine the incremental earnings from the purchase of the XC-750. c. If the appropriate cost of capital for the expansion is 10.2%, compute the NPV of the purchase. d. While the expected new sales will be $10 million per year from the expansion, estimates range from $8.05 million to $11.95 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 break-even level for the cost of goods sold as a percentage of sales? f. Billingham could instead purchase the XC-900, which offers even greater capacity. The cost of the XC-900 is $4 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 million expected for the XC-750) per year in those years would justify purchasing the larger machine?
