Question

AAI specializes in production of music equipment. The firm incurred $3.2 million to do feasibility study of the new equipment. The projected sales volume of a new seven-octave voice emulation implant is as follow

Year	1	2	3	4	5
Sales volume (Millions)	10	12	16	14	12

Production of the implants will require $15 million in net working capital (NWC) immediately. Thereafter, NWC investment will equal to 20% of projected sales revenue.

Each implant is priced to sell at $35 with a variable cost of $23 per unit. Annual total operating fixed costs amount to $30 million. The production of the implants will require acquisition of computerized machine at a cost of $240 million. The acquisition of the machine is partly financed with a 5-year, 4%, $150 million amortizable loan. The machine is industrial machinery which qualifies as a seven-year MACRS property.

The introduction of the music equipment will reduce after-tax cash flows of existing music equipment by $ 5 million per year for the first three years and $3 million per year for the last 2 years.

In five years, the firm projects that it will sell the computerized machine at a price approximately equal to about 20% of depreciable cost. The firm is in the 25% marginal tax rate. The cost of capital is 18%.

Required:

1. Compute the depreciation per year and after-tax salvage value of the machine
2. Compute investment in NWC each year and recovered/terminal cash flows of NWC
3. Derive the OCF, CFO and FCF of the project

Answer 1

Section 1 Solution

Year	Adjusted Basis	Rate %	Depreciation	Cumulative	Book Value	Method
2020	24,00,00,000	14.29	3,42,85,714	3,42,85,714	20,57,14,286	DB
2021	20,57,14,286	24.49	5,87,75,510	9,30,61,224	14,69,38,776	DB
2022	14,69,38,776	17.49	4,19,82,507	13,50,43,732	10,49,56,268	DB
2023	10,49,56,268	12.49	2,99,87,505	16,50,31,237	7,49,68,763	DB
2024	7,49,68,763	8.92	2,14,19,647	18,64,50,884	5,35,49,116	SL
2025	5,35,49,116	8.92	2,14,19,647	20,78,70,530	3,21,29,470	SL
2026	3,21,29,470	8.92	2,14,19,647	22,92,90,177	1,07,09,823	SL
2027	1,07,09,823	4.46	1,07,09,823	24,00,00,000	0	SL

DB - Declining balance, SL- Straight Line

Book Value in 5 years                     = 32,129,470

Salvage value of asset                     = 240,000,000 x 20/100

                                                          = 48,000,000

Taxable value on LTCG                   = 48,000,000 - 32,129,470

                                                         = 15,870,530

Marginal Tax rate = 25% ( No Information given about marginal tax slabs )

                                                         = 3,967,632.5

Net Proceeds from sale = 48,000,000 - 3,967,632.5

                                                          = 44,032,367.5

Section 2 & 3 Solution

Please find the attached excel snippet for the calculations of section 2 and 3. follow the columns for for annual NWC, OCF, CFO and FCF and the project totals in their respective column totals. Financing cost ( 4% of 150 Million distributed over a period of 5 years) is mentioned below is included in the calculation of FCF

А M Unit Year NWC Sales vol Sales Variable Cost Fixed Cost Total Cost Cash from operations - CFO Operating Cash Flow - OCF Free Cash Flow - Working CAPEX" FCF price Initial 15,000,000.00 2,000,000.00 2,400,000.00 3,200,000.00 2,800,000.00 2,400,000.00 10,000,000.00 12,000,000.00 16,000,000.00 14,000,000.00 12,000,000.00 35.00 35.00 35.00 35.00 35.00 35.00 350,000,000.00 420,000,000.00 560,000,000.00 490,000,000.00 420,000,000.00 Variable cost per unit 23.00 23.00 23.00 23.00 23.00 23.00 230,000,000.00 276,000,000.00 368,000,000.00 322,000,000.00 276,000,000.00 3,200,000.00 30,000,000.00 30,000,000.00 30,000,000.00 30,000,000.00 30,000,000.00 3,200,000.00 260,000,000.00 306,000,000.00 398,000,000.00 352,000,000.00 306,000,000.00 350,000,000.00 420,000,000.00 560,000,000.00 490,000,000.00 420,000,000.00 -3,200,000.00 90,000,000.00 114,000,000.00 162,000,000.00 138,000,000.00 114,000,000.00 2,700,000.00 360,000.00 432,000.00 576,000.00 504,000.00 432,000.00 -5,900,000.00 88,440,000.00 112,368,000.00 160,224,000.00 136,296,000.00 112,368,000.00 | 2,240,000,000.00 614,800,000.00 5,004,000.00 603,796,000.00 12 Other Annual Capital Expenditure (CAPEX) items 1,200,000.00 14 5 year Asset Financing cost 15