Question

A firm is evaluating a new project which would start next year and is expected to have a life of 5 years. All of the following are related to the project. Which of the following should be included into the Free Cash Flow when computing the NPV of the project?

1. Operating Cash Flows (OCF) from this project derived from an Income Statement Pro-Forma, where all project related revenues and costs (including taxes but not interest) are accounted for every year of the project. OCF does not account for depreciation of the project-specific equipment per se but takes into account the depreciation tax shield.
2. Half of the $100,000 cost of the quality check equipment which will be used for this project. The quality check equipment is currently owned by the firm and has idle capacity for the full duration of the new project.
3. $3mln paid for the land (the payment was made when the land was purchased 10 years ago) on which the project will be located.
4. $5mln current market value of the land on which the project will be located and $6mln future expected market value of the project’s land in 5 years
5. The change in Inventories due to an increase in sales associated with the project.
6. An evaluation of the project’s viability by an outside consultant which was completed a month ago. The consultant was paid $15,000 at that time.
7. Proceeds from the sale of equipment related to the project in the project’s terminal year.

Answer 1

Free Cash Flow of the Firm can be calculated as follows:

Free Cash Flow to the Firm		Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Operating Cash Flow		x	x	x	x	x	x
Consultant Fee		15,000
EBIT		xx	x	x	x	x	x
Tax Rate, %	30.0%	30.0%	30.0%	30.0%	30.0%	30.0%	30.0%
EBIT x (1 - Tax Rate)		yy	yy	yy	yy	yy	yy
Add: Depreciation & amortization of Quality Check Equipment			100,000	100,000	100,000	100,000	100,000
Less: Change in WC due to inventory
Less: CAPEX (ex. Acquisitions + Divestitures) 3 Million Paid for Land		3,000,000
Free Cash Flow to the Firm		zz	zz	zz	zz	zz	zz
Terminal value - Proceeds from sale of equipment		1.0	2.0	3.0	4.0	5.0	xx
Present Value		Year 0	PV(Year 1)	PV(Year 2)	PV(Year 3)	PV(Year 4)	PV(Year 5)
Present Value of Free Cash Flow = Aggregate PV of all 5 years

After operating cash flows, 15,000 $ consultant fee will be reduced in Year 0.

Tax Rate is assumed as 30% for illustration.

Add back Depreciation on the use of half value of quality check equipment will be allocated evenly over the 5 year period since it's a non-cash expense.

Less: Amount paid towards purchase of CAPEX - Land of 3 Million $

Less; Changes in working capital due to inventory

Terminal value will appear in Year 5

Take PV of all years respectively at the rate provided.

Aggregate of all Present Values is the Total Free Cash Flow to the Firm.