Question

Question: In the Case, when calculating incremental unlevered net income, should we include all the expenses mentioned in the case? If not, what expenses should we exclude and why?

(I know that I need to exclude interest expenses but can someone let me know if I also need to exclude overhead expenses? I am confused) Other than that I don't think I missed anything else but, feel free to correct me if I am wrong.

Information:

Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment.

• The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite).

• Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity.

• The cost of goods sold is estimated to be 72% of sales.

• The accounting department also estimates that at introduction in Year 0, the new product's required initial net working capital will be $6,000,000. In future years accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next year’s cost of goods sold and accounts payable are expected to be 15% of the next year’s cost of goods sold.

• The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted.

• The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year.

• The annual interest expense tied to the project is $1,000,000.

• Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%.

Answer 1

No. Overhead expenses should not be excluded for calculating unlevered net income.

Only interest expenses on debt & other financial obligations , need to be excluded.

That is, income should be calculated , as if there is no debt , for the firm.

But, the tax(cash outflow) savings due to these interest expenses--ie. Interest tax shields--will be added to the Net PV of the unlevered Free cash flows.

Here, I have assumed 20% , cost of capital given , as the cost of equity

As interest rates are not available, PV of interest tax shields had been calculated , based on this 20% only.

Year	0	1	2	3	4	5	6
Operating cash flows:
1.Sales revenues		30000000	31800000	33708000	35730480	37874309	40146767
3.COGS(Sales*72%)		-21600000	-22896000	-24269760	-25725946	-27269502	-28905672
5.Incremental S,G & A(6-1)mln.		-5000000	-5000000	-5000000	-5000000	-5000000	-5000000
7.St. line depn.(9 mln./5)		-1800000	-1800000	-1800000	-1800000	-1800000	0
8.Incremental EBIT(sum 1,3,5,7)		1600000	2104000	2638240	3204534	3804806	6241095
9.Incl.Tax expense(Row 8 *30%)		-480000	-631200	-791472	-961360	-1141442	-1872328
10.Incl.EAT/NOPAT(Incl.Unlevered net income)(8+9)		1120000	1472800	1846768	2243174	2663365	4368766	Ans.1
11.Add Back: Depn.(row 7)		1800000	1800000	1800000	1800000	1800000	0
12.Unlevered Opg. Cash flows(10+11)		2920000	3272800	3646768	4043174	4463365	4368766
CAPEX & NWC Cash flows
13.Initial investment	-9000000
14.NWC reqd.	6000000
15.A/cs receivables(Next yr. sales*15%)		4770000	5056200	5359572	5681146	6022015	0
16.Inventory(Next yr.COGS*20%)		4579200	4853952	5145189	5453900	5781134	0
17.A/cs payable(Next yr COGS*15%)		-3434400	-3640464	-3858892	-4090425	-4335851	0
18.Total level ofNWC needed for the yr.(sum 14 to 17)	6000000	5914800	6269688	6645869	7044621	7467299	0
19.Change in NWC(yr.0-Yr.1)& so on	-6000000	85200	-354888	-376181	-398752	-422677	7467299
20.After-tax one-time Market research exp.(500000*(1-30%))		-350000
21.Total annual unlevered FCFs(12+13+19+20)	-15000000	2655200	2917912	3270587	3644422	4040687	11836065	Ans.2
22. Terminal FCF(11836065*1.02/(20%-2%))							67071036	Ans.3
23.Total FCFs(21+22)	-15000000	2655200	2917912	3270586.7	3644422	4040687.2	78907101
24..PV F at 20%(1/1.20^Yr.n)	1	0.83333	0.69444	0.57870	0.48225	0.40188	0.33490	3.32551
25.PV at 20%(21*22)	-15000000	2212666.7	2026328	1892700.6	1757534	1623861.6	26425828	(PV factor for i=20%, 6 yrs)
26.NPV of unlevered FCFs(sum of row 23)	20938919	Ans.4
27..PV of interest tax shields(1000000*30%*3.32551)	997653		jeff jeffy Next > < Previous Related Solutions Question: In Case 1, when calculating incremental unlevered net income, should we include all the expenses... Question: In Case 1, when calculating incremental unlevered net income, should we include all the expenses mentioned in the case? If not, what expenses should we exclude and why? Case 1: Chem Tough Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Chem Tough is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment.... Why do we want to include Net Working Capital in our calculation to convert unlevered net... Why do we want to include Net Working Capital in our calculation to convert unlevered net income to free cash flow? 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