Houston Pumps recently reported $232,500 of sales, $140,500 of operating costs other than depreciation, and $9,250...

Houston Pumps recently reported $232,500 of sales, $140,500 of operating costs other than depreciation, and $9,250 of depreciation. The company had $35,250 of outstanding bonds that carry a 6.75% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate future sales and cash flows, the firm was required to spend $15,250 to buy new fixed assets and to invest $6,850 in net operating working capital. What was the firm's free cash flow? a. 44,622 b. 45,031 c. 47,897 d. 47,488 e. 40,938

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Expert Solution

Free cash flow to firm is calculated using the formula:

Where

EBIT is earnings before interest and taxes
t is the tax rate

One thing to note here is that we exclude the effect of interest tax shield while calculating FCFF i.e. we use earnings before interest, rather than after interest, to calculate taxes (The term EBIT(1-t) is adjusting the firm's EBIT for taxes). We do so because we include the effect of interest tax shield when we calculate WACC or weighted average cost of capital when we adjust the cost of debt by (1-t). So, in order to avoid double counting we don't consider the effects of interest tax shield.

The computation is as shown below:

So, the correct option is e.

jeff jeffy answered 1 year ago

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