Question

​(Calculating free cash flows​) Spartan Stores is expanding operations with the introduction of a new distribution center. Not only will sales increase but investment in inventory will decline due to increased efficiencies in getting inventory to showrooms. As a result of this new distribution​ center, Spartan expects a change in EBIT of ​$900,000. Although inventory is expected to drop from ​$89,000 to ​$62,000​, accounts receivables are expected to climb as a result of increased credit sales from ​$80,000 to ​$190,000. In​ addition, accounts payable are expected to increase from ​$67,000 to ​$84,000. This project will also produce ​$300,000 of bonus depreciation in year 1 and Spartan Stores is in the 35 percent marginal tax rate. What is the​ project's free cash flow in year​ 1?

Answer 1

The free cash flows can be computed using the formula :

Free Cash flow = EBIT - Taxes+ Depreciation & amortisation- Change in working capital.

In the given question, we are given the changes in current assets such as inventory and accounts receivables and changes in current liability of accounts payable. We use these figures to arrive at changes in working capital. Net working capital= Current Assets - Current liabilities. This will give the changes in working capital.

The taxes are deducted from EBIT as it is a cash outflow. The depreciation is added back since it is a non cash item. Finally, we deduct the Changes in working capital as it reflects the requirement for cash to arrive at Free Cash Flow