Question

Apple is planning to launch a new easy-to-use kitchen appliance with a touchscreen interface, the iToaster. Apple expects to sell 1 million and 2 million units in the first two years after launch, respectively, and then to discontinue this product. Each unit will sell for $200 in the first year after launch, and $150 in the second year. The costs of components and labor are $80 per unit, while salaries and other expenses add up to $10 million in each year the product is sold.

The factory that manufactures the iToaster requires an investment of $90 million right now and $45 million one year from now. It will take one year to complete, so production will only start in the second year, i.e. at the end of year 2 followed by one more year of production in at the end of year 3. The factory will be depreciated linearly to zero over 5 years after its completion.

To get production up and running, Apple has to buy components worth $5 million immediately before the launch of the product, and add another $2 million worth of components to its inventory exactly one year later.

The firm's marginal tax rate is 34%.

1. What is the annual depreciation (in $ million)?
2. What is the net operating profit after taxes in year 2 (in $ million)?
3. What is the net operating profit after taxes in year 3 (in $ million)?
4. What is the free cash flow (FCF) at the end of year 0 (in $ million)?
5. What is the free cash flow (FCF) at the end of year 1 (in $ million)?
6. What is the free cash flow (FCF) at the end of year 2 (in $ million)?

Answer 1

Answer (a):

The factory that manufactures the iToaster requires an investment of $90 million right now and $45 million one year from now.

Total cost of project = 90 + 45 = $135 million

The factory will be depreciated linearly to zero over 5 years after its completion.

Annual Depreciation = (Cost - Residual value) / Useful life = (135 - 0) / 5 = $27 million

Annual Depreciation = $27 million

Answer (b):

FCF =

Net operating profit after taxes in year 2 (in $ million)

= ((Sale price - Variable cost) * Unit Sales - Fixed cost - Depreciation)) * (1 - Tax rate)

= ((200 - 80) * 1 - 10 - 27) * (1 - 34%)

= $54.78 Million

Net operating profit after taxes in year 2 (in $ million) = $54.78 Million

Answer (c):

Net operating profit after taxes in year 3 (in $ million)

= ((Sale price - Variable cost) * Unit Sales - Fixed cost - Depreciation)) * (1 - Tax rate)

= ((150 - 80) * 2 - 10 - 27) * (1 - 34%)

= $67.98 Million

Net operating profit after taxes in year 3 (in $ million) = $67.98 Million

Answer (d):

FCF = Net operating profit after taxes + Depreciation - Capital Expenses - Increase in working capital

Free cash flow (FCF) at the end of year 0 (in $ million) = 0 + 0 - 90 - 0 = - $90 million

Free cash flow (FCF) at the end of year 0 (in $ million) = -$90 million or ($90) million

Answer (e):

FCF = Net operating profit after taxes + Depreciation - Capital Expenses - Increase in working capital

Free cash flow (FCF) at the end of year 1 (in $ million) = 0 + 0 - 45 - 5 = - $50 million

Free cash flow (FCF) at the end of year 1 (in $ million) = - $50 million or ($50) million

Answer (f):

FCF = Net operating profit after taxes + Depreciation - Capital Expenses - Increase in working capital

Free cash flow (FCF) at the end of year 2 (in $ million) = 54.78 + 27 - 0 - 2 = $79.78 million

Free cash flow (FCF) at the end of year 2 (in $ million = $79.78 million