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(Calculating free cash flows) At present, Solartech Skateboards is considering expanding its product line to include...
(Calculating free cash flows) At present, Solartech Skateboards is considering expanding its product line to include gas-powered skateboards; however, it is questionable how well they will be received by skateboarders. Although you feel there is a 50 percent chance you will sell 10,000 of these per year for 10 years (after which time this project is expected to shut down because solar-powered skateboards will become more popular), you also recognize that there is a 25 percent chance that you will only sell 5,000 and also a 25 percent chance you will sell 17,000. The gas skateboards would sell for $110 each and have a variable cost of $35 each. Regardless of how many you sell, the annual fixed costs associated with production would be $130,000. In addition, there would be an initial expenditure of $1,000,000 associated with the purchase of new production equipment which will be depreciated using the bonus depreciation method in year 1. Because of the number of stores that will need inventory, the working capital requirements are the same regardless of the level of sales. This project will require a one-time initial investment of $30,000 in net working capital, and working-capital investment will be recovered when the project is shut down. Finally, assume that the firm's marginal tax rate is 21 percent.
a. What is the initial outlay associated with the project?
b. What are the annual free cash flows associated with the project for years 1, and 2 through 9 under each sales forecast? What are the expected annual free cash flows for year 1, and years 2 through 9?
c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 10 plus any additional cash flows associated with the termination of the project)?
d. Using the expected free cash flows, what is the project's NPV given a required rate of return of 9 percent? What would the project's NPV be if 10,000 skateboards were sold?
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Ans.
| Calculation of expected annual sales units: | ||
| No. of units | Probability | Probability adjusted units |
| 10,000 | 0.5 | 5,000.00 |
| 5,000 | 0.25 | 1,250.00 |
| 17,000 | 0.25 | 4,250.00 |
| 10,500.00 |
Therefore, total expected sale ( no. of units ) = 10,500 units.
a)
Calculation of initial outlay associated with the project:
| Purchase of new equipment | $ 1,000,000.00 |
| Investment in net Working Capital | $ 30,000.00 |
| Total Initial Outlay | $ 1,030,000.00 |
b)
Calculation of annual cash flows of the project for years 1 to 9 under different sales scenarios:
| Case 1 | Case 2 | Case 3 | |
| No of units sold | 10,000 | 5,000 | 17,000 |
| Selling price per unit | 110 | 110 | 110 |
| Variable Cost per unit | 35 | 35 | 35 |
| Contribution per unit ( selling price less variable cost ) | 75 | 75 | 75 |
| Contribution for the year | 750,000.00 | 375,000.00 | 1,275,000.00 |
| Fixed Costs per Year | 130,000.00 | 130,000.00 | 130,000.00 |
| Depreciation per year | 100,000.00 | 100,000.00 | 100,000.00 |
| Profit before tax | 520,000.00 | 145,000.00 | 1,045,000.00 |
| Tax @ 21% | 109,200.00 | 30,450.00 | 219,450.00 |
| Profit after tax | 410,800.00 | 114,550.00 | 825,550.00 |
| Free Cash Flow | 510,800.00 | 214,550.00 | 925,550.00 |
Calculation of expected annual cash flows of project for years 1 to 9
| No. of units expected to be sold ( as calculated at the top) | 10,500 |
| Selling price per unit | 110 |
| Variable Cost per unit | 35 |
| Contribution per unit ( selling price less variable cost ) | 75 |
| Contribution for the year | 787,500.00 |
| Fixed Costs per Year | 130,000.00 |
| Depreciation per year | 100,000.00 |
| Profit before tax | 557,500.00 |
| Tax @ 21% | 117,075.00 |
| Profit after tax | 440,425.00 |
| Free Cash Flow | 540,425.00 |
c)
Calculation of free cash flow in year 10
| Case 1 | Case 2 | Case 3 | |
| Annual cash flow from operations ( as calculated in (b) above) | 510,800 | 214,550 | 925,550 |
| Recovery of working capital investment | 30,000 | 30,000 | 30,000 |
| Total free cash flows for year 10 | 540,800 | 244,550 | 955,550 |
d)
Calculation of NPV of the project
| Year 0 | Year1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 | Year 9 | Year 10 | |
| Expected annual cash flow from operations | - | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 |
| Initial Cash Outlay | (1,030,000.00) | - | - | - | - | - | - | - | - | - | |
| Recovery of working capital investment | - | - | - | - | - | - | - | - | - | - | 30,000.00 |
| Total free cash flow for the year | (1,030,000.00) | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 540,425.00 | 570,425.00 |
| Present value factor @ 9% | 1 | 0.917431193 | 0.841679993 | 0.77218348 | 0.708425211 | 0.649931386 | 0.596267327 | 0.547034245 | 0.50186628 | 0.46042778 | 0.422410807 |
| Discounted FCF | (1,030,000) | 495,803 | 454,865 | 417,307 | 382,851 | 351,239 | 322,238 | 295,631 | 271,221 | 248,827 | 240,954 |
| Net Present Value | 2,450,935 |
Calculation of NPV of the project based on sales of 10,000 units.
| Year 0 | Year1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 | Year 9 | Year 10 | |
| Expected annual cash flow from operations | - | 510,800.00 | 510,800.00 | 510,800.00 | 510,800.00 | 510,800.00 | 510,800.00 | 510,800.00 | 510,800.00 | 510,800.00 | 510,800.00 |
| Initial Cash Outlay | (1,030,000.00) | - | - | - |
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