Billingham 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 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 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 Billinghams 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 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. Billinghams marginal corporate tax rate is 35%. a. Determine the incremental earnings from the purchase of the XC-750. 0 150.0 150.0 19 100.0 35.0 10.0 15.0 40.0 14.0 26.0 15.0 5.0 36.0 10 100.0 35.0 10.0 15.0 40.0 14.0 26.0 15.0 5.0 12.0 48.0 Year Revenues Manufacturing Expenses (other than depreciation) Marketing Expenses Depreciation EBIT Taxes at 35% Unlevered Net Income Depreciation Additions to Net Working Capital Capital Expenditures Continuation Value Free Cash Flow 1 2 3 4 5 6 7 8 9 10 11 12 13 M09_BERK5561_04_SE_C09.indd 299 09/12/2016 14:48 300 Part 3 Valuation and the Firm You have just been hired by Intel in its finance division. Your first assignment is to determine the net cash flows and NPV of a proposed new generation of mobile chips. Capital expenditures to produce the new chips will initially require an investment of $1.2 billion. The R&D that will be required to finish the chips is $500 million this year. Any ongoing R&D for upgrades will be covered in the margin calculation in 2a below. The product family is expected to have a life of five years. First-year revenues for the new chip are expected to be $2,000,000,000 ($2,000 million). The chip familys revenues are expected to grow by 20% for the second year, and then decrease by 10% for the third, decrease by 20% for the 4th and finally decrease by 50% for the 5th (final) year of sales. Your job is to determine the rest of the cash flows associated with this project. Your boss has indicated that the operating costs and net working capital requirements are similar to the rest of the companys products. Since your boss hasnt been much help, here are some tips to guide your analysis: 1. Obtain Intels financial statements. Download the annual income statements and balance sheets for the last four fiscal years from Google Finance (finance.google .com). Enter Intels ticker symbol (INTC) and then go to Financials. Click Annual, to ensure youre getting annual, instead of quarterly, data. Next, copy and paste the income statements and balance sheets into Excel. 2. You are now ready to determine the free cash flow. Compute the free cash flow for each year using Eq. 9.6 from this chapter: Free Cash Flow = $++++++++++%++++++++++& Unlevered Net Income (Revenues - Costs - Depreciation) * (1 - Tax Rate) + Depreciation - CapEx - Change in NWC Data Case 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. 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 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 $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 through 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?