Question

Persimmon, Inc. is considering a 3 year project. Your boss said to you​ “We owe these consultants​ $1.2 million for this report. Before we spend​ $15 million on new equipment needed for this​ project, look it over and give me your​ opinion.” Here are the​ report’s estimates​ (in millions of​ dollars):

​[BE SURE TO SCROLL DOWN TO SEE THE ENTIRE​ QUESTION.]

    

	1	2	3
Sales Revenue	25	25	25
-Cogs	13	13	13
Gross Profit	12	12	12
Selling, General, expenses	3	3	3
-Depreciation	5	5	5
Net operating income	4	4	4
-Income tax	1	1	1
Net income	3	3	3

Everything that the consultants have calculated is​ correct, as far as it goes. This is the incremental net income for this project. Do not change the use of straight line depreciation over three years​ (this is a simplified​ problem). Your job is to determine if there are any further adjustments we need to get the correct incremental FCFs to used in calculating the NPV.

This project will require​ $17 million in working capital upfront​ (year 0), which will be fully recovered in the last year of the project​ (year 3).   

What are the correct free cash flows​ (FCFs) for evaluating this​ project?  

​(a) Start from the correct Net Income which has already been given​ (you do NOT need to recopy the calculations before​ NI).

​(b) Make any additional adjustments needed for each of the​ periods, in order to get the entire final set of FCFs. Show each of the adjustments.

​(c) Do not calculate the NPV​ – just give the final FCF stream.  

​[Note for online​ version: ​ Don't worry too much about​ formatting, but type out your answer and try to make it clear what you are​ doing, by labelling everything. ​ Explain/label well enough that I can give you partial credit if you​ don't get the exact answer. And note that this will show as you having gotten zero points​ initially, because it will be graded by hand​ later.]

                                                                                                                                             

Answer 1

Find below the Final Free Cash Flow Stream:

Thus, FCF for year 0 is -$32 Million, year 1 and 2 is $8 Million each and year 3 is $25 Million

Note:

1. From the net income, depreciation is added back to arrive at the operating cash flow. Depreciation is added back as it is a non-cash item

2. $1.2 million to be paid to consultants for preparing the report is a sunk cost and doesn't impact the future cash-flows. Hence the same is not be considered as part of free cash-flows.

3. The question doesn't mention selling the new equipment at the end of year 3 and hence no sale value is considered. Also, the book value of the machine is zero at the end of year 3 (Cost - Depreciation for 3 years).

Workings: