Question

(a) The Minimax project requires the initial purchase of equipment costing $72,000, which will be depreciated fully using the straight-line method over 3 years for tax purposes. Initially there will be an addition to working capital of $5,000 which will be recovered in the final year of the project. The project is expected to be operational for four years. At the end of the fourth year the project is expected to be sold for $12,000. The project will produce 25,000 units annually which will be sold at $6.00 per unit. Operational expenses include a fixed cost of $7,000 annually and a cost of production of $2.80 per unit. The relevant tax rate is 30%. Calculate the free cash flows for the initial phase (Year 0), the ongoing phase (Years 1 – 3) and the terminal phase (Year 4). (b) State the four possible uses by a firm of “free cash flows” (c) Mango Media expects free cash flows of $9 million each year. Mango’s corporate tax rate is 40%, and its unlevered cost of capital is 15%. The firm also has outstanding debt of $26 million, and it expects to maintain this level of debt permanently. (i) What is the value of Mango Media without leverage? (ii) What is the value of Mango Media with leverage?

Answer 1

Year	0	1	2	3	4
1.Initial purchase	-72000
2.NWC added & recovered	-5000				5000
3.After-tax sale value (12000*(1-30%))					8400
Operating cash flows
4.Sales units		25000	25000	25000	25000
5.Sales $ at $ 6/unit		150000	150000	150000	150000
6.Fixed cost		-7000	-7000	-7000	-7000
7. Cost of production(4*$2.80)		-70000	-70000	-70000	-70000
8.Depreciation(72000/3)		-24000	-24000	-24000	-24000
9. EBT(5+6+7+8)		49000	49000	49000	49000
10.Tax at 30%(9*30%)		-14700	-14700	-14700	-14700
11.EAT/NOPAT(9+10)		34300	34300	34300	34300
12.Add Back: depn.(row 8)		24000	24000	24000	24000
13 Net operating cash flow(11+12)		58300	58300	58300	58300
14.Total annual Free cash flows(1+2+3+13)	-77000	58300	58300	58300	71700
so, the answers are:	Free cash flows
Initial phase(Yr.0)	-77000
the ongoing phase (Years 1 – 3)	58300
the terminal phase (Year 4)	71700

(b)Four possible uses by a firm of “free cash flows”

1.For purchase of fixed assets , ie. Capital expenditure, or expansion of existing facilities

2. To repay existing debt

3. To pay dividends to shareholders

4. Increase net working capital

5. Share repurchases

6. Acqusition of a new company, etc.

c.

i) Value of Mango Media without leverage

Assuming perpetual FCFs,

V0=FCF/Unlevered Cost of capital

ie. 9 mln./15%=

60

mlns.

(Answer)

(ii)Value of Mango Media with leverage

Unlevered value +PV of debt tax shield(which is Debt*Interest%*tax rate)/Interest %)

so, V0=60+(26*40%)=

70.4

mlns.

(Answer)