Question

Krypton Engineering expects to have net profit next year of $ 16.01 million and free cash flow of $ 22.36 million. ​ Krypton's marginal corporate tax rate is 40 %. a. If Krypton increases leverage so that its interest expense rises by $ 4.8 ​million, how will its net profit​ change? b. For the same increase in interest​ expense, how will free cash flow​ change?

Answer 1

a) New net profit, if interest expense rises by $4.8 million

New net profit = (Old net profit before tax - Interest) * (1 - Tax rate)

Here, Tax rate = 40% or 0.40, Interest = $4.8 millon

Old net profit before tax = Old profit / (1 - Tax rate)

Old net profit before tax = $16.01 million /(1 - 0.40)

Old net profit before tax = $26.68 million

Now,

New net profit = ($26.68 - $4.8) * (1 - 0.40)

New net profit = $21.88 * 0.60

New net profit = $13.128 million

Change in net profit = Old profit - New profit

Change in net profit = $16.01 - $13.128

Change in net profit (reduced) = $2.882 million

b) New free cash flow = Old free cash flow + Interest - Tax shield on interest

Here,

Tax shield on interest = Interest * Tax rate

Tax shield on interest = $4.8 million * 40%

Tax shield on interest = $1.92 million

Now,

New free cash flow = $22.36 million + $4.8 million - 1.92 million

New free cash flow = $25.24 million

Change in free cash flow = New free cash flow - Old free cash flow

Change in free cash flow = $25.24 - $22.36

Change in free cash flow (increased) = $2.88 million