Question

You are evaluating a new product. In year 3 of your​ analysis, you are projecting pro forma sales of ​$5 million and cost of goods sold of ​$3 million. You will be depreciating a ​$1 million machine for 5 years using​ straight-line depreciation. Your tax rate is 35​%. ​Finally, you expect working capital to increase from $200,000 in year 2 to ​$300,000 in year 3. What are your pro forma earnings for year​ 3? What are your pro forma free cash flows for year​ 3?

Answer 1

Cost of Machine = $1,000,000
Useful Life = 5 years

Depreciation Expense = Cost of Machine / Useful Life
Depreciation Expense = $1,000,000 / 5
Depreciation Expense = $200,000

Operating Income = Sales - Cost of Goods Sold - Depreciation Expense
Operating Income = $5,000,000 - $3,000,000 - $200,000
Operating Income = $1,800,000

Earnings = Operating Income * (1 - Tax Rate)
Earnings = $1,800,000 * (1 - 0.35)
Earnings = $1,170,000

Change in Net Working Capital = Net Working Capital, Year 3 - Net Working Capital, Year 2
Change in Net Working Capital = $300,000 - $200,000
Change in Net Working Capital = $100,000

Free Cash Flows = Earnings + Change in Net Working Capital
Free Cash Flows = $1,170,000 + $100,000
Free Cash Flows = $1,270,000