Question

Chip’s Home Brew Whiskey management forecasts that if the firm sells each bottle of Snake-Bite for $20, then the demand for the product will be 15,000 bottles per year. Whereas Sales will equal only 89 percent of this amount if the price is raised 10 percent. Chip’s variable cost per bottle is $10, and the total fixed cash cost for the year is $100,000. Depreciation and amortization charges are $20,000, and the firm has a 30 percent marginal tax rate. Management anticipates an increased working capital need of $3,000 for the year. What will be the effect of a 10 percent price increase on the firm’s FCF for the year?

Answer 1

Let's call the forecasts corresponding to the two situations as Forecast 1 and 2.

Under forecast 1:

• Sale Price, P = $ 20 per bottle
• Sale volume, Q = 15,000 bottles

Under forecast 2

• Sale price, P = 10% more than forecast 1 sale price = $ 20 x (1 + 10%) = $ 22 per bottle
• Sale Volume, Q = 89% of forecast 1 sale volume = 89% x 15,000 = 13,350 bottles

Now, please see the table below. The second column titled "Linkage" explains how each row has been calculated.

Parameter	Linkage	Forecast 1	Forecast 2
Sale Price	P	20	22
Sale Volume	Q	15,000	13,350
Revenue	R = P x Q	300,000	293,700
Variable cost per bottle	V	10	10
Total Variable Cost	VC = V x Q	150,000	133,500
Fixed Cost	FC	100,000	100,000
Depreciation & amortization expenses	D	20,000	20,000
Operating income	EBIT = R - VC - FC -D	30,000	40,200
Marginal tax rate	t	30%	30%
Taxes	T = t x EBIT	9,000	12,060
NOPAT	EBIT - T	21,000	28,140
Free Cash flow calculation
NOPAT = EBIT x (1 - t)	NOPAT	21,000	28,140
[+] Depreciation & amortization	D	20,000	20,000
[-] Increase in working capital	Increase in WC	3,000	3,000
FCFF	NOPAT + D - Increase in WC	38,000	45,140

Hence,  the effect of a 10 percent price increase on the firm’s FCF for the year = FCFF under Forecast 2 - FCFF under forecast 1 = 45,140 - 38,000 = $ 7,140 increase.