1. (Calculating free cash flows) Racin' Scooters is introducing a new product and has an expected change in EBIT of $475,000. Racin' Scooters has a 34 percent marginal tax rate. The project will also produce $100,000 of depreciation per year. In addition, the project will also cause the following changes in year 1:
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WITHOUT THE PROJECT
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WITH THE PROJECT
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Accounts receivable
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545,000
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$63,000
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Inventory
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65,000
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80,000
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Accounts payable
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70,000
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94,000
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What is the project's free cash flow in year 1?
2. (New project analysis) The Chung Chemical Corporation is considering the purchase of a chemical analysis machine. Although die machine being considered will result in an increase in earnings before interest and taxes of $35,000 per year, it has a purchase price of $100,000, and it would cost an additional $5,000 to properly install the machine. In addition, to properly operate the machine, inventory must be increased by $5,000. This machine has an expected life of 10 years, after which it will have no salvage value. Also, assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 15 percent.
a. What is the initial outlay associated with this project?
b. What are the annual after-tax cash flows associated with this project for years I through 9?
c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with die termination of the project)?
d. Should this machine be purchased?
3. (Comprehensive problem) The Shome Corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, is considering a new project. The project involves the introduction of a new product. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. Given the following information, determine the free cash flows associated with the project, the project's net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria.
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Cost of new plant and equipment
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$6,900,000
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Shipping and installation costs
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$ 100,000
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Unit sales
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YEAR
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UNITS SOLD
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1
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80,000
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2
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100,000
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3
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120,000
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4
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70,000
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5
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70,000
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Sales price per unit
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$250/unit In years 1 through 4, $200/unit In year 5
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Variable cost per unit
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$ 130/units
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Annual fixed costs
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$300,000 per year in years 1-5
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Working-capital requirements
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There will be an initial working-capital requirement of $100,000 Just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the Investment In working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital Is liquidated at the termination of the project at the end of year 5.
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The depreciation method
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Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years.
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4. (Real options and capital budgeting) You have come up with a great idea for a Tex-Mex-Thai fusion restaurant. After doing a financial analysis of this venture, you estimate that the initial outlay will be $6 million. You also estimate that there is a 50 percent chance that this new restaurant will be well received and will produce annual cash flows of $800,000 per year forever (a perpetuity), while there is a 50 percent chance of it producing a cash flow of only $200,000 per year forever (a perpetuity) if it isn't received well.
a. What is the NPV of the restaurant if the required rate of return you use to discount the project cash flows is 10 percent?
b. What are the real options that this analysis may be ignoring?
c. Explain why the project may be worthwhile even though you have just estimated that its NPV is negative.