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%. Required: 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”.

Answer 1

	Answer a.
	Minimax Project
	Cash flow Analysis
	Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
	Ininitial Investments
	Purchase of Equipment	$      (72,000)
	Additional working capital Investment	$        (5,000)
a	Total Initial Investment	$      (77,000)
	Cash flow from Operations
	Annual Revenue @$6/unit for 25000 units		$      150,000	$      150,000	$      150,000	$      150,000
	Annual Variable cost of Production @$2.8/unit		$         70,000	$         70,000	$         70,000	$         70,000
	Annual Fixed cost		$           7,000	$           7,000	$           7,000	$           7,000
	Depreciation		$         24,000	$         24,000	$         24,000	$                 -
	EBT		$         49,000	$         49,000	$         49,000	$         73,000
	Tax @30%		$         14,700	$         14,700	$         14,700	$         21,900
	PAT		$         34,300	$         34,300	$         34,300	$         51,100
	Add back depreciation		$         24,000	$         24,000	$         24,000	$                 -
b	Cash flow from Operations =PAT+Deprn=		$         58,300	$         58,300	$         58,300	$         51,100
	Terminal Cash flow
	Working Capital Returned					$           5,000
	Post Tax salvage value=12000*(1-30%)=					$           8,400
c	Total Terminal Cash flow					$         13,400
		Year 0	Year 1	Year 2	Year 3	Year 4
d	Total Cash flow =a+b+c	$      (77,000)	$         58,300	$         58,300	$         58,300	$         64,500

Ans b.

Some possible uses of the free cash flow generated by a firms are the following ;

1. To use for investment in new proftable projects

2. To pay dividends

3 To repay debts to reduce the debt burden.

4. Use to fund Working capital requirements

5. To buy back stocks to consolidate holding.