Question

LP's owners had been offering engine adaptor kits for some time but have recently decided to begin building their own units. To make the adaptor kits the firm would need to invest in a variety of machine tools costing a total of ​$700,000. ​LP's management estimates that they will be able to borrow ​$400,000 from the​ firm's bank and pay 8 percent interest. The remaining funds would have to be supplied by​ LP's owners. The firm estimates that they will be able to sell​ 1,000 units a year for ​$1,300 each. The units would cost ​$1,000 each in cash expenses to produce​ (this does not include depreciation expense of ​$70,000 per year or interest expense of ​$32,000​). After all​ expenses, the firm expects earnings before interest and taxes of ​$230,000. The firm pays taxes equal to 30 ​percent, which results in net income of ​$129,000 per year over the 10​-year expected life of the equipment.The annual free cash flow LP should expect to receive from the investment in years 1 through 10 is? The anticipated NPV of the investment is?

Answer 1

The following table shows the Free Cash Flow:

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Net Income (+)	$        129,000	$      129,000	$      129,000	$      129,000	$      129,000	$      129,000	$      129,000	$      129,000
Interest Expense (+)	$          32,000	$         32,000	$         32,000	$         32,000	$         32,000	$         32,000	$         32,000	$         32,000
Tax Shield (-)	$            9,600	$           9,600	$           9,600	$           9,600	$           9,600	$           9,600	$           9,600	$           9,600
Depreciation (+)	$          70,000	$         70,000	$         70,000	$         70,000	$         70,000	$         70,000	$         70,000	$         70,000
Capex (-)	$        700,000	$                 -	$                 -	$                 -	$                 -	$                 -	$                 -	$                 -
Free Cash Flow	$      (478,600)	$      221,400	$      221,400	$      221,400	$      221,400	$      221,400	$      221,400	$      221,400

The NPV calculation requires an estimate of Cost of Equity which is not mentioned in the question. Assuming Cost of equity to be 10%:

WACC = Ke * E/(D+E) + Kd * D/(D+E) * (1-Tax)

The WACC = 10% * 3/7 + 8%*4/7 * (1-30%)

=7.5%

Hence NPV = $ 869,450