10. Capital Budgeting Problem

Vatsa Packaging is considering expanding its production capacity by purchasing a new machine, the MCC-750. The cost of the MCC-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 MCC- 750, resulting in the following estimates:

• Marketing: Once the MCC-750 is operating 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. Once the machine is operating next year, the cost of goods for the products produced by the MCC-750 is expected to be 70% of their sale price. The increased production will require additional inventory on hand of $1 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 MCC-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. Assume that cash requirements are 1.5 times the Accounts Receivable Vatsas marginal corporate tax rate is 21%.

1. Determine the incremental earnings from the purchase of the MCC-750.

2. Determine the free cash flow from the purchase of the MCC-750.

3. If the appropriate cost of capital for the expansion is 10%, compute the NPV of the purchase.