Question

Hannaford Enterprises reported earnings before interest, taxes, depreciation and amortization (EBITDA) of $ 500 million in 2017. The firm had depreciation of $80 million and reported capital expenditures of $ 120 million. The book value of the invested capital was $2,000 million. The firm’s total working capital increased from $80 million to $180 million, but half of this increase was due to an increase in the cash balance; the firm has no short-term debt. The firm has a tax rate of 30%. In addition, the firm also invests considerable amounts in research and development (R&D) each year. The R&D expenses for the current and prior 5 years are as follows: $80 million (2017), $100 million (2016), $70 million (2015), $60 million (2014), $65 million (2013), $90 million (2012). Finally, the firm acquired another firm for $150 million during 2017 and reported amortization of $40 million for the year, which is not tax deductable.

(a) Estimate the free cash flow to the firm (FCFF) assuming capitalising the R&D expenses. Tip: notice the impact of the capitalisation on FCFF.

(b) Determine the return on capital (ROC) before and after capitalising the R&D expenses, assuming 5 years of amortisable life.

Answer 1

Basic information
	(2017)
	$ in millions
EBITDA	500
Depreciation	80
Amortization	40
EBIT	380
Tax (500-80)*30%	126
EAT (Earning after Tax)	254
Capital Expenditure during 2017	$ 120 millions
R&D Expenses Capitalised during 2017	$ 80 millions
Total Capital Expenditure for the year 2017	$ 200 millions
Non Cash Working capital increase	$ 50 millions
(180-80)/2
Investment Capital book value	$ 2,000 millions
Amortization Accumulated Account	$ in millions
2012	90
2013	65
2014	60
2015	70
2016	100
2017	80
Total	465
Amortization for 2017	40
(a) Free Cash Flow (FCF) = Net Income + Non cash expenses - working capital increased - Capital Expenditure
	(2017)
	$ in millions
Net Income	254
Non Cash Expenses (Depreciation+Amortization)	120
Working capital increased	-50
Capital Expenditure	-200
Free Cash Flow of the Firm (FCFF)	124
(b)
Return on Capital (ROC) = Net Operating profit after tax /Invested Capital
ROC = (254+40)/2000*100	14.70%
( before capitalisatio of R&D Expense & amortization)
ROC = 254/2000*100	12.70%
( after capitalisatio of R&D Expense & amortization)
Note : It is assumed $ 40 millions reported amortization is including of all
R&D expenses done in last 5 year as per 5 year amortization life basis.