Question

Billingham Packaging is considering expanding its production capacity by purchasing a new machine, the XC-750. The cost of the XC-750 is $2.69 million. Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $46,000 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 $10.00 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 $5.07 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 68% of their sale price. The increased production will also require increased inventory on hand of $1.07 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 $1.94 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 14% of revenues and payables to be 11% of the cost of goods sold. Billingham's marginal corporate tax rate is 35%. Billingham could instead purchase the XC-900, which offers even greater capacity. The cost of the XC-900 is $4.08 million. The extra capacity would not be useful in the first two years of operation, but would allow for additional sales in years 3-10. What kind of real option does the XC-900 machine provide to Billingham? What kind of real option does the XC-900 machine provide to Billingham? (Select all the choices that apply.) A. If it would be beneficial to expand production, Billingham will increase production with the XC-900. B. The XC-900 allows Billingham the option to expand production starting in year 3. C. If it would be better if production remains the same, Billingham is under no obligation to utilize all of the XC-900 production capacity. D. The expansion will require additional sales and administrative personnel.

Answer 1

Analysis of various options:-

The company is looking to expand its production capacity by purchasing a new machine. The first option is to buy XC-750 which will take few months to install and will get operational from next year where onwards the extra sales would start kicking in. This means that there is extra demand in the market that exists and as per the question the extra demand is at least as much as the extra capacity of XC-750.

As an alternative, the company can buy another machine XC-900 whose capacity will be more than the capacity of XC-750. The question mentions that the "extra capacity" will not be useful in first 2 years.

If we assume that this means that XC-900 will take 2 years to install and that's why extra sales can kick in only from 3rd year onwards, than the real option that XC-900 will be providing is to expand production from 3rd year onwards and correct option would have been option B. However, it is not a right assumption as the question hasn't mentioned anything like that. Therefore, option B is wrong.

The correct assumption to make is that the market's demand in next two years is not enough to use to extra capacity of XC-900 over and above the extra capacity of XC-750. The fact that XC-750 can be put to use next year's means that there is enough demand in the market for its level of extra capacity but the enough demand is not there to put complete extra capacity of XC-900 to use for next 2 years. In other words, the company can expand production a little as suggested by dynamics of XC-750 but can't increase it completely upto the levels of XC-900 total extra capacity.

Therefore, options A and C represent the correct real option that XC-900 provides the company, i.e. if the prevailing market situation doesn't allow opportunity to benefit from expanding production, then the company wouldn't be under the obligation to do it. If it's beneficial to expand production as per prevailing market demand, it would expand the production.

As far as option D is concerned, no doubt expansion by XC-900 will required additional workforce for sales and administration, however, it doesn't represent any option to the company which is what the question has asked to identify. Therefore, the option D is wrong.

Therefore, the correct options are A and C.