Question

Question:

In Case 1, when calculating incremental unlevered net income, should we include all the expenses mentioned in the case? If not, what expenses should we exclude and why?

Case 1:

Chem Tough Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Chem Tough is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment.

 The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite).

 Chem Tough anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity.

 The cost of goods sold is estimated to be 72% of sales.

 The accounting department also estimates that at introduction in Year 0, the new product's required initial net working capital will be $6,000,000. In future years accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next year’s cost of goods sold and accounts payable are expected to be 15% of the next year’s cost of goods sold.

 The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted.

 The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year.

 The annual interest expense tied to the project is $1,000,000.

 Chem Tough has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%.

Answer 1

Unlevered Free Cash flow can be calculated as:

EBIT (Earnings Before Interest & taxes)*(1-Tax Rate)

Add: Depreciation & Amortization

Less: Capital Expenditure

Less: increase in Working Capital

{Since it is unlevered cashflows - taxes are recalculated before deducting interest expenses}

a) $500,000 spent on research - this is already spent and will not have an impact on the future cashflow generation capability of the project. However the initial investment requirement of $9 Mn will be considered to evaluate the project and hence included in the cashflows as Capital Expenditure.

b) Depreciation expenses will be calculated on the basis of Taxation. $9Mn will be depreciated on a straight line basis for 5 years implying a depriciation expense of $1.8 Mn. Depreciation expense gives the project cashflows, a tax benefit i.e lower taxes on lower EBIT due to higher depreciation expense

c) Revenues will be considered to calculate the EBIT, However, while considering the revenues - only the incremental revenue from introduction of the new asset should be considered.

d) Cost of goods sold will be considered to compute the EBIT

e) Increase in working capital requirements will be deducted to arrive at the unlevered cashflows

f) Only $5Mn of the SG&A will be considered to arrive at the EBIT, since $1mn of the total SG&A of $6Mn is an overhead expenses that will be incrurred even if the project is not accepted. It is a sunk cost

g) the market research expense will not be considered - since it is also a sunk cost.

h) Annual interest expenses are not considered, since we are calculating unlevered cashflows.

i) cost of capital = 20%, we discount the unlevered cashflows basis 20%

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Terminal Value
Revenue		30,000,000	31,800,000	33,708,000	35,730,480	37,874,309	40,146,767	40,949,703
Cost of Good Solds		21,600,000	22,896,000	24,269,760	25,725,946	27,269,502	28,905,672	29,483,786
SG&A		5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000
Depreciation		1,800,000	1,800,000	1,800,000	1,800,000	1,800,000
EBIT		1,600,000	2,104,000	2,638,240	3,204,534	3,804,806	6,241,095	6,465,917
Less Taxes		1,120,000	1,472,800	1,846,768	2,243,174	2,663,365	4,368,766	4,526,142
Add: Depreciation		1,800,000	1,800,000	1,800,000	1,800,000	1,800,000	0	0
Less: Capex	9,000,000
AR (15% of Revenue)		4,500,000	4,770,000	5,056,200	5,359,572	5,681,146	6,022,015	6,142,455
Inventory(20% of Cost of Goods Sold)		4,320,000	4,579,200	4,853,952	5,145,189	5,453,900	5,781,134	5,896,757
AP (15% of Cost of Goods Sold)		3,240,000	3,434,400	3,640,464	3,858,892	4,090,425	4,335,851	4,422,568
Working Capital		5,580,000	5,914,800	6,269,688	6,645,869	7,044,621	7,467,299	7,616,645
Less: Increase in Working Capital	6,000,000	-420,000	334,800	354,888	376,181	398,752	422,677	149,346
Unlevered CashFLows	-15,000,000	2,700,000	2,096,400	2,236,584	2,385,179	2,542,690	1,449,651	1,790,429
Terminal Value							9,946,828
Total Cashflows	-15,000,000	2,700,000	2,096,400	2,236,584	2,385,179	2,542,690	11,396,479
Discounted at Cost of Capital	-15,000,000	2,250,000	1,455,833	1,294,319	1,150,260	1,021,850	3,816,658
NPV	-4,011,079

Terminal Value = Cashflow in Year 7/(WACC - Perpetual growth)