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 25.0    25.0                                                       25.0

​- Cost of goods sold 13.0         13.0              13.0

Gross profit                                       12.0     12.0                12.0

​-Selling, general and
administrative expenses 3.0 3.0    3.0

​-Depreciation                                    5.0 5.0 5.0

Net operating income 4.0 4.0 4.0

​- Income tax 1.0 1.0 1.0

Net Income                                       3.0 3.0 3.0

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

Based on the given data, pls find below workings:

- The initial cash outflow for the cost of equipment need to be considered in Year 0;

- Since this consultancy is exclusively for this project, the cost need to be included in Year 0;

- Additional working capital is a cash outflow and hence need to be considered in Year 0; Since the same is recovered after Year 3, the recovery is considered in Terminal Year;

- Since depreciation is a Non-Cash expense (only used for Tax benefits), the same is added back to the Net Income to calculate actual Operational Cash flows for Year 1 to Year 3;

Project ($)	Year 0	Year 1	Year 2	Year 3	Terminal
Cost of New Equipment	-15.0
Consultancy Fee	-1.2
Increase in working capital	-17.0				17.0
Net Income as Given		3.0	3.0	3.0
Add: Depreciation		1.0	1.0	1.0
Free Cash Flows (Net Income + Depreciation + WC Changes)	-33.2	4.0	4.0	4.0	17.0