Reference no: EM132983828

Question - A company is planning to expand production by purchasing a new machine.

The cost of the machine is €8.25 million.

The installation will take several months and production will be disrupted.

€50,000 was spent on a feasibility study to analyze the decision to buy the machine and the impact that this will have on costs and revenues.

Once in operation next year, the extra capacity is expected to generate €30 million per year in additional sales for the next 10 years (life expectancy).

The disruption caused by the installation will decrease sales by €15 million this year and the expansion will require additional sales and administrative personnel at a cost of €6 million per year.

The cost of goods sold is in all cases expected to be 70% of the sales price and the increase in volume will require an additional €1.8 million of working capital this year and €3.6 million next year.

Of this total of €5.4 million, €3 million is expected to be recovered in year 10 and the remainder a year later.

The machine will be depreciated via the straight-line method over the 10-year life of the machine.

The marginal corporate tax rate is 35%.

Required -

a. What are the incremental earnings from the purchase of the machine?

b. What are the incremental free cash flows from the purchase of the machine?

c. If the appropriate cost of capital for the expansion is 10%, what is the NPV of the purchase?

The company is considering debt financing.

The project could support a debt-to-value ratio of 45% and the borrowing rate would be 5%.

d. If the project is financed with debt, what is the NPV of the project to purchase the machine?

e. Explain the relationship between the NPVs you have calculated in parts (c.) and (d).