Question

You have just been hired by Internal Business Machines Corporation (IBM) in their capital budgeting division. Your first assignment is to determine the free cash flows and NPV of a proposed new type of tablet computer similar in size to an iPad but with the operating power of a high-end desktop system. Development of the new system will initially require an initial capital expenditure equal to 10% of IBM’s Property, Plant, and Equipment (PPE) at the end of fiscal year 2014. The project will then require an additional investment equal to 10% of the initial investment after the first year of the project, a 5% increase after the second year, and a 1% increase 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 IBM’s total revenue for the fiscal year 2014. The new product’s revenues are expected to grow at 15% for the second year 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 indicated that the operating costs and net working capital requirements are similar to the rest of the company and that depreciation is straight-line for capital budgeting purposes. Since your boss hasn’t been much help (welcome to the “real world”!), here are some tips to guide your analysis: Obtain IBM’s financial statements. (If you really worked for IBM you would already have this data, but at least you won’t get fired if your analysis is off target.) Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from Yahoo! Finance (finance.yahoo.com). Enter IBM’s ticker symbol and then go to “financials.” You are now ready to estimate the Free Cash Flow for the new product. Compute the Free Cash Flow for each year using Eq. 8.5: Free Cash Flow = Unlevered Net Income  ( Revenues − Costs − Depreciation ) × ( 1 − τ c ) + Depreciation − CapEx − Δ N W C Free Cash Flow =(Revenues−Costs−Depreciation)×(1−τc)︷Unlevered Net Income+Depreciation−CapEx−ΔNWC Set up the timeline and computation of free cash flow in separate, contiguous columns for each year of the project life. Be sure to make outflows negative and inflows positive. Assume that the project’s profitability will be similar to IBM’s existing projects in 2014 and estimate ( revenues − costs ) (revenues−costs) each year by using the 2014 EBITDA/Sales profit margin. Calculate EBITDA as EBIT + Depreciation EBIT+Depreciation expense from the cash flow statement. Determine the annual depreciation by assuming IBM depreciates these assets by the straight-line method over a 5-year life. Determine IBM’s tax rate by using the income tax rate in 2014. 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 IBM’s 2014 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 not necessarily reflective of the project’s required NWC—for example, IBM’s cash holdings.) To determine the free cash flow, deduct the additional capital investment and the change in net working capital each year. Use Excel to determine the NPV of the project with a 12% cost of capital. Also calculate the IRR of the project using Excel’s IRR function. Perform a sensitivity analysis by varying the project forecasts as follows: Suppose first year sales will equal 2%–4% of IBM’s revenues. Suppose the cost of capital is 10%–15%. Suppose revenue growth is constant after the first year at a rate of 0%–10%.

Answer 1

Solution: The following is the working table of NPV of the project along with Free Cash Flows and Income Statement for the new project. The NPV is negative thus the project is not viable.

	Year 1	Year 2	Year 3	Year 4	Year 5
Revenues	2783790.00	3201358.50	3521494.35	3697569.07	3882447.52
Op Cost	2179707.57	2506663.71	2757330.08	2895196.58	3039956.41
Op Profit	604082.43	694694.79	764164.27	802372.49	842491.11
Depreciation	215420.00	236962.00	259581.10	282426.39	305500.13
PBT	388662.43	457732.79	504583.17	519946.10	536990.98
Tax	82357.569	96993.579	106921.17	110176.58	113788.39
PAT	306304.86	360739.22	397662.00	409769.52	423202.59
CF	521724.86	597701.22	657243.10	692195.91	728702.72
(PAT + Depreciation)

Year	Initial Investment	Change in NWC	Cash Flows	Free Cash Flows	DF @12%	PV
0	-1077100.00	0.00	-1077100.00	-1077100.00	1.000	-1077100
1	-107710.00	-217135.62	521724.86	196879.24	0.893	175785
2	-113095.50	-249705.96	597701.22	234899.76	0.797	187260.6
3	-114226.46	-274676.56	657243.10	268340.09	0.712	190999.2
4	-115368.72	-288410.39	692195.91	288416.80	0.636	183294.1
5	-116522.41	-302830.91	728702.72	309349.41	0.567	175533.2
					NPV	-164228

In the lowest Cost of Capital and the Highest Consistent Sales growth of 10% also NPV is coming as -131230.

The main assumptions are Depreciation calculated as per Straight Line Method for 5 years for Initial Investment too not for the remaining life of the project. It is not getting clear from the question. Other than that all the necessary data for FY 2014 being picked from Yahoo Finance Site.