The break-even level of new sales

Buckingham Packaging is considering expanding its production capacity by purchasing a new machine, the XC-750. The cost of the XC-750 is $2.75 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 analyse 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 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 million this year. As with Buckingham’s existing products, the cost of goods for the products produced by the XC-750 is expected to be 70% of their sale price. The increased production will also require increased inventory on hand of $1 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 $2 million per year.

• Accounting: The XC-750 has a CCA rate of 30%, and no salvage value is expected. The firm expects receivables from the new sales to be 15% of revenues and payables to be 10% of the cost of goods sold. Buckingham’s marginal corporate tax rate is 35%.

a. Determine the incremental earnings (using CCA) 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%, compute the NPV of the purchase (including all CCA tax shield effects).

d. While the expected new sales will be $10 million per year from the expansion, estimates range from $8 million to $12 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?

f. Buckingham 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 to 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?

Solution:

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