Question

?(Determining relevant cash? flows)??Landcruisers Plus? (LP) has operated an online retail store selling? off-road truck parts. As the name? implies, the firm specializes in parts for the venerable Toyota FJ40 that is known throughout the world for its durability and offroad prowess. The fact that Toyota stopped building and exporting the FJ40 to the U.S. market in 1982 meant that FJ40 owners depended more and more on? re-manufactured parts to keep their beloved? off-road vehicles running. More and more FJ40 owners are replacing the original inline? six-cylinder engines with a modern? American-built engine. The engine replacement requires mating the new engine with the Toyota drive train. ?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 ?$850,000. ?LP's management estimates that they will be able to borrow ?$340,000 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 ?$1,450 each. The units would cost ?$1,000 each in cash expenses to produce? (this does not include depreciation expense of ?$85,000 per year or interest expense of ?$27,200?).After all? expenses, the firm expects earnings before interest and taxes of ?$365,000. The firm pays taxes equal to 31 ?percent, which results in net income of ?$224,650 per year over the 10?-year expected life of the equipment.

a.??What is the annual free cash flow LP should expect to receive from the investment in year 1 assuming that it does not require any other investments in either capital equipment or working capital and the equipment is depreciated over a 10?-year life to a zero salvage and book? value? How should the financing cost associated with the ?$340,000 loan be incorporated into the analysis of cash? flow?

b.??If the? firm's required rate of return for its investments is13 percent and the investment has a 10?-year expected? life, what is the anticipated NPV of the?investment?

Answer 1

First let us write down all the inputs given in the question

Inputs

Cost of Machine	$850,000
Sales Unit	1000
Sale Price	$1,450
Unit Cost	$1,000
Depreciation	$85,000
Interest Expenses	$27,200
Tax Rate	31%
Years	10
Rate of Return	13%

Part a:

Particulars	Year 1
Revenues (1000 * 1450)	$1,450,000
Cost (1000 * 1000)	($1,000,000)
Depreciation	($85,000)
Operating Income	$365,000
Taxes @ 31%	($113,150)
Operating profit after tax	$251,850
Depreciation	$85,000
Free cash flow	$336,850

Free cash flow will be same for all the 10 years i.e. $336,850 each year.

Part b:

The cost of debt financing should not be included into the analysis of cash flow. The interest expense is omitted from above.

Calculation of NPV:

NPV = a/r * [1 – (1/1+r)ⁿ] – Initial Investment

Where;

a = cash flow

r = rate of return

n = no. of period

NPV = $336,850/13% * [1 – (1/1+13%)¹⁰] – $850,000

         = $977,830