Question

You have just been hired by IBM in their capital budgeting division. Your first assignment is to determine the free cash flows and NPV of a proposed new type of tablet.

The project has an expected life of 5 years

Development of the new system will initially require an initial capital expenditure equal to 10% of IBM’s gross property, plant, and equipment in 2018 (balance sheet). The project will then require an additional capital expenditure investment equal to 10% of the initial investment in the first year of project, a 5% increase after the second year, and a 1% increase after the third, fourth, and fifth years.

First-year revenues for the new product are expected to be 3% of IBM’s total revenue for 2018 (income statement). The new product’s revenues are expected to grow at 15% for the second year, 10% for the third, and 5% annually for the final two years of the expected life of the project.

Assume that initial capital expenditure incurred in year 0 will be depreciated using a straight line method over a five-year life.

Calculate average gross profit margin for 2015-2018 and use it to calculate project’s costs.

Calculate IBM’s average NWC/Sales for 2015-2018 and use it to calculate net working capital required in years 1 through 5 of the project.

Calculate average tax expense for 2015-2018 (tax expense/pretax income) and apply it to calculate free cash flows.

1. Calculate free cash flows for years 0-5 of the project
2. If IBM’s beta is 1.56, risk free rate is 2%, and return of the market portfolio is 10%, calculate IBM’s cost of capital using CAPM
3. Calculate NPV of the project
4. Should IBM take this project?

Balance sheet:

	12/31/18	12/31/17	12/31/16	12/31/15
Cash
Cash And Cash Equivalents	11,379,000,000	11,972,000,000	7,826,000,000	7,686,000,000
Short Term Investments	618,000,000	608,000,000	701,000,000	508,000,000
Net Receivables	29,820,000,000	30,649,000,000	28,188,000,000	27,353,000,000
Inventory	1,682,000,000	1,583,000,000	1,553,000,000	1,551,000,000
Other Current Assets	1,000,000	-1,000,000	-1,000,000	0
Total Current Assets	49,146,000,000	49,735,000,000	43,888,000,000	42,504,000,000
Gross property, plant and equipment	32,461,000,000	32,331,000,000	30,134,000,000	29,341,000,000
Accumulated Depreciation	-21,668,000,000	-21,215,000,000	-19,303,000,000	-18,616,000,000
Net property, plant and equipment	10,793,000,000	11,116,000,000	10,831,000,000	10,725,000,000
Equity and other investments	226,000,000	122,000,000	104,000,000	475,000,000
Goodwill	36,265,000,000	36,788,000,000	36,199,000,000	32,021,000,000
Intangible Assets	3,088,000,000	3,741,000,000	4,689,000,000	3,486,000,000
Other long-term assets	296,000,000	572,000,000	729,000,000	571,000,000
Total non-current assets	74,237,000,000	75,620,000,000	73,584,000,000	67,987,000,000
Total Assets	123,382,000,000	125,356,000,000	117,470,000,000	110,495,000,000
Total Revenue	10,207,000,000	6,986,000,000	7,513,000,000	6,461,000,000
Accounts Payable	6,558,000,000	6,451,000,000	6,209,000,000	6,028,000,000
Taxes payable
Accrued liabilities	3,941,000,000	4,510,000,000	4,705,000,000	4,353,000,000
Deferred revenues	11,165,000,000	11,552,000,000	11,035,000,000	11,021,000,000
Other Current Liabilities	7,251,000,000	1,000,000	1,000,000	-1,000,000
Total Current Liabilities	38,227,000,000	37,363,000,000	36,275,000,000	34,269,000,000
Long Term Debt	35,605,000,000	39,837,000,000	34,655,000,000	33,428,000,000
Deferred taxes liabilities	3,696,000,000	545,000,000	424,000,000	253,000,000
Deferred revenues	3,445,000,000	3,746,000,000	3,600,000,000	3,771,000,000
Other long-term liabilities	1,719,000,000	1,721,000,000	1,778,000,000	2,063,000,000
Total non-current liabilities	68,226,000,000	70,268,000,000	62,803,000,000	61,802,000,000
Total Liabilities	106,453,000,000	107,631,000,000	99,078,000,000	96,071,000,000
Common Stock	55,151,000,000	54,566,000,000	53,935,000,000	53,262,000,000
Retained Earnings	159,206,000,000	153,126,000,000	152,759,000,000	146,124,000,000
Accumulated other comprehensive income	-29,490,000,000	-26,592,000,000	-29,398,000,000	-29,607,000,000
Total stockholders' equity	16,796,000,000	17,594,000,000	18,246,000,000	14,262,000,000
Total liabilities and stockholders' equity	123,382,000,000	125,356,000,000	117,470,000,000	110,495,000,000

Income Statements:

	12/31/18	12/31/17	12/31/16	12/31/15
Total Revenue	79,590,000,000	79,139,000,000	79,920,000,000	81,742,000,000
Cost of Goods Sold	42,655,000,000	42,913,000,000	41,625,000,000	41,057,000,000
Gross Profit	36,935,000,000	36,226,000,000	38,295,000,000	40,685,000,000
Research Development	5,379,000,000	5,787,000,000	5,751,000,000	5,247,000,000
Selling General and Administrative	18,863,000,000	19,555,000,000	20,479,000,000	19,894,000,000
Operating Income or Loss/EBITDA/EBIT	12,693,000,000	10,884,000,000	12,065,000,000	15,544,000,000
Interest Expense	723,000,000	615,000,000	630,000,000	468,000,000
Total Other Income/Expenses Net	-1,482,000,000	17,000,000	-339,000,000	421,000,000
Income Before Tax	10,488,000,000	10,286,000,000	11,096,000,000	15,497,000,000
Income Tax Expense	2,619,000,000	5,642,000,000	449,000,000	2,581,000,000
Net Income	7,869,000,000	4,644,000,000	10,647,000,000	12,916,000,000

Answer 1

Year	0	1	2	3	4	5
1.Capital Investment	-3246.1	-324.61	-340.8405	-344.248905	-347.691	-351.168
starts with (32461*10%)
Revenues(79590*3%)		2387.7	2745.855	3020.4405	3171.463	3330.036
Costs(52.53%*Rev.)wkgs.		-1254.25881	-1442.397632	-1586.637395	-1665.97	-1749.27
Depn.(3246.1/5)		-649.22	-649.22	-649.22	-649.22	-649.22
EBT		484.22119	654.2373685	784.5831054	856.2733	931.5479
Tax at 25.13%*EBT		-121.684785	-164.4098507	-197.1657344	-215.181	-234.098
EAT		362.536405	489.8275178	587.417371	641.0918	697.4499
Add back: depn.		649.22	649.22	649.22	649.22	649.22
2.Opg. CF		1011.756405	1139.047518	1236.637371	1290.312	1346.67
NWC reqd.(12.24%*rev.)(wkgs.)	292.2545	336.092652	369.7019172	388.18701	407.5964	0
3.Change in NWC	-292.254	-43.838172	-33.6092652	-18.48510	-19.4094	407.5964
4. FCFs(1+2+3)	-3538.35	643.308233	764.5977526	873.9033701	923.211	1403.098
5.PV F at 14.48%(1/1.1448^Yr.n)	1	0.87352	0.76303	0.66652	0.58221	0.50857
6.PV at 14.48%(4*5)	-3538.35	561.9394068	583.4098747	582.4713276	537.505	713.5754
7.NPV (sum row 6)	-559.453
C. NO.
(negative NPV)
		Workings
			12/31/2018	12/31/2017	2016	2015
		COGS	42655	42913	41625	41057
		Revenues	79590	79139	79920	81742
		COGS/Rev.	53.59%	54.22%	52.08%	50.23%
		Av. COGS/Rev.	52.53%
		(sum/4)
		Total Current Assets	49,146	49,735	43,888	42,504
		Total current liabilities	38227	37363	36275	34269
		NWC	10,919	12,372	7,613	8,235
		Revenues	79590	79139	79920	81742
		NWC/Revenues	13.72%	15.63%	9.53%	10.07%
		Av. NWC/Sales	12.24%
		(sum/4)
		Income Before Tax	10488	10286	11096	15497
		Income Tax Expense	2619	5642	449	2581
		tax exp./pretax inc.	24.97%	54.85%	4.05%	16.65%
		Av.Tax exp./Pre-tax inc.	25.13%
		(sum/4)
		IBM's cost of equity
		as per CAPM,
		RFR+(beta*Mkt.return-RFR)
		ie.2%+(1.56*(10%-2%))=
		14.48%