You have just been hired by Hewlett Packard (HP) in its capital budgeting division. Your first assignment is to determine the net cash flows and NPV of a proposed new type of portable computer similar in size to an iPhone, but which has the operating power of a high-end desk top system
Development of the new system will initially require an investment equal to 10% of net property, plant, and equipment for the fiscal year ended October 31, 2012. The project will then require an additional investment equal to 10% of the initial investment after the first year of the project, 5% of the initial investment after the second year, and 1% of the initial investment after the third, fourth, and fifth years. The product is expected to have a life of five years. First-year revenues for the new product are expected to be 3% of total revenue for HP's fiscal year ended October 31, 2012. The new product's revenues are expected to grow at 15% for the second yearm then 10% for the third, and 5% annually for the final two years of the expected life of the project. Your job is to determine the rest of the cash flows associated with this project. Your boss has indicatied that the operating costs and net working capital requirements are similar to the rest of the company's products and that depreciation is straight-line for capital budgeting purposes. Welcome to the "real world." Since your boss hasn't been much help, here are some tips to guide your analysis.
1. Obtain HP's financial statements. Download the annual incomr statements, balance sheets, and cash flow statements for the last four fiscal years from Google finance (finance.google.com). Enter the HP ticker symbol (HPQ) and then go to "financials." Click "Annual" to ensure youre getting annual, instead of quartlerly data. Next, copy and paste the income and balance sheets into Excel.
2. You are now ready to determine the free cash flow. Compute the free cash flow for each year using the following equation
Free Cash Flow= frac{Unlevered Net Income}{(revenues-costs-depreciation)cdot (1-Tax Rate)+Depreciation-CapEx-Change in NWC}
Set up the timeline and computation of the free cash flow in separate, contiguous columns for each year of the project life. Be sure to make outflows negative and inflows positive.
a.) Assume that the project's profitability will be similar to HP's existing projects in 2012 and estimate (Revenues-Costs) each year by the EBITDA/Sales profit margin
b.) Determing the annual depreciation by assuming HP depreciates these ssets by the straight line method over a ten year life
c.) Determine HP's tax rate by dividing HP's income taxes by it's income before tax in 2012.
d.) Calculate the net working capital required each year by assuming that the level of NWC will be a constant percentage of the project's sales. Use HP's 2012 NWC/Sales to estimate the required percentage. (Use only accounts receivable, accounts payable, and inventory to measure working capital. Other components of current assets and liabilities are harder to interpret and are not necessarily reflective of the projects required NWC-e.g. HP's Cash Holdings)
e.) To determine the free cash flow, calculate additional capital investment and the change in net working capital each year
3. Determine the IRR of the project and the NPV of the project at a cost of capital of 12% using the excel functions. For the calculation of NPV, include cash flows 1 through 5 in the NPV function and then subtract the initial cost (i.e. NPV(rate, CF1:CF5)+CF0). For IRR, include cash flows 0 though 5 in the cash flow range.