Billingham Packaging is considering expanding its production capacity by purchasing a new machine, the XC-750. The cost of the XC-750 is

$2.82

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

$48,000

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

$10.20

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

$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

72%

of their sale price. Theincreased 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

$2.04

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

10%

of the cost of goods sold.Billingham's marginal corporate tax rate is

21%.

Billingham could instead purchase the XC-900, which offers even greater capacity. The cost of the XC-900 is

$4.04

million. The extra capacity would not be useful in the first two years of operation, but would allow for additional sales in years3-10.

a. What kind of real option does the XC-900 machine provide to Billingham?

b. If Billingham knows that it can sell the XC-750 to another firm for

$2.08

million in two years, what kind of real option would that provide?

Question content area bottom

Part 1

a. What kind of real option does the XC-900 machine provide to Billingham?(Select all the choices that apply.)

A.

The expansion will require additional sales and administrative personnel.

B.

If it would be beneficial to expand production, Billingham will increase production with the XC-900.

C.

The XC-900 allows Billingham the option to expand production starting in year 3.

D.

If it would be better if production remains the same, Billingham is under no obligation to utilize all of the XC-900 production capacity.

Part 2

b. If Billingham knows that it can sell the XC-750 to another firm for

$2.08

million in two years, what kind of real option would that provide?(Select the best choice.)

A.

Billingham will no longer depreciate the machine.

B.

This provides Billingham the option to abandon the investment.

C.

The firm can recover the feasibility study cost.

D.

The decreased production will also require decreased inventory.