Problem
Auer Industriesis considering purchasing a new machine, the XD-750, which would allow it to expand its production capacity. The cost of the XD-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 XD-750, resulting in the following estimates: Marketing: Once the XD-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 XD-750 is expecte4d to be 70% of their sales price. The increase 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 willrequire additional sales and administrative personnel at a cost of $2 million per year. Accounting: The XD-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. Billingham's marginal corporate tax rate is 35%.
I. Determine the incremental earnings from the purchase of the XD-750.
II. Determine the free cash flow from the purchase of the XD-750.