Question

IBM is considering a new expansion project and the finance staff has received information summarized below:

- The project require IBM to purchase $1,000,000 of equipment in 2013 (t=0) - Inventory will increase by $100,000 and accounts payable will rise by $50,000

- The project will last for four years. The company forecasts that they will sell 1,000,000 units in 2014, 2,000,000 units in 2015, 3,000,000 units in 2016, and 4,000,000 units in 2017. Each unit will sell for $3.00

- The fixed cost of producing the product is $2 million each year

- The variable cost of producing each unit is $1.00 each year

- The equipment will be depreciated under the MACRS system using the applicable rates of 33%, 45%, 15%, and 7% respectively

- When the project is completed in 2017 (t=4), the company expects that it will be able to salvage the equipment for $100,000, and it expects that it will fully recover the NWC.

- The estimated tax rate is 40% - Based on the perceived risk, the project's WACC is estimated to be 12%

1. Create the projected Free Cash Flow Schedule for the project

2. Use the capital budgeting techniques to evaluate free cash flows

Answer 1

Working capital = Inventory - account payable

= 100,000 - 50,000

= 50,000

Cash outflow = purchase price + working capital

= 1,000,000 + 50,000

= 1,050,000

Free cash flow schedule

Year (units)	1	2	3	4
Sales (Rs 3 per unit)	3,000,000	6,000,000	9,000,000	12,000,000
(-)Variable Cost (Rs 1 per unit)	(1,000,000)	(2,000,000)	(3,000,000)	(4,000,000)
(-) Fixed cost	(2,000,000)	(2,000,000)	(2,000,000)	(2,000,000)
Ebitda	0	2,000,000	4,000,000	6,000,000
(-)depreciation	(297,000)	(405,000)	(135,000)	(63,000)
EBT	(297,000)	1,595,000	3,865,000	5,937,000
(-) Tax (40%)	(118,800)	(638,000)	(1,546,000)	(2,374,800)
Net Profit	(415,800)	957,000	2,319,000	3,562,200
(+)Depreciation	297,000	405,000	135,000	63,000
(+)Working capital				50,000
Free cash flow	(118,800)	1,362,000	2,454,000	3,675,200

Depreciation =( purchase price - salvage value) × depreciation rate

2. Using calculator to calculate Npv and irr

Inputs : C0 = -1,050,000

C1 = -118,800. Frequency= 1

C2 = 1,362,000. Frequency= 1

C3 = 2,454,000. Frequency= 1

C4 = 3,675,200. Frequency= 1

I = 12%

Npv = compute

Irr = compute

We get, Npv = $4,012,785.69

  Irr = 84.16%