Question

You have just been hired by Internal Business MachinesCorporation (IBM) in their capital budgeting division. Your firstassignment is to determine the free cash flows and NPV of aproposed new type of tablet computer similar in size to an iPad butwith the operating power of a high-end desktop system. Developmentof the new system will initially require an initial capitalexpenditure equal to 10% of IBM’s Property, Plant, and Equipment(PPE) at the end of fiscal year 2014. The project will then requirean additional investment equal to 10% of the initial investmentafter the first year of the project, a 5% increase after the secondyear, and a 1% increase after the third, fourth, and fifth years.The product is expected to have a life of five years. First-yearrevenues for the new product are expected to be 3% of IBM’s totalrevenue for the fiscal year 2014. The new product’s revenues areexpected to grow at 15% for the second year then 10% for the thirdand 5% annually for the final two years of the expected life of theproject. Your job is to determine the rest of the cash flowsassociated with this project. Your boss has indicated that theoperating costs and net working capital requirements are similar tothe rest of the company and that depreciation is straight-line forcapital budgeting purposes. Since your boss hasn’t been much help(welcome to the “real world”!), here are some tips to guide youranalysis: Obtain IBM’s financial statements. (If you really workedfor IBM you would already have this data, but at least you won’tget fired if your analysis is off target.) Download the annualincome statements, balance sheets, and cash flow statements for thelast four fiscal years from Yahoo! Finance (finance.yahoo.com).Enter IBM’s ticker symbol and then go to “financials.” You are nowready to estimate the Free Cash Flow for the new product. Computethe Free Cash Flow for each year using Eq. 8.5: Free Cash Flow =Unlevered Net Incomeî î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î “î ’î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ‘ (Revenues − Costs − Depreciation ) × ( 1 − τ c ) + Depreciation −CapEx − Δ N W C Free Cash Flow=(Revenues−Costs−Depreciation)×(1−τc)︷Unlevered NetIncome+Depreciation−CapEx−ΔNWC Set up the timeline and computationof free cash flow in separate, contiguous columns for each year ofthe project life. Be sure to make outflows negative and inflowspositive. Assume that the project’s profitability will be similarto IBM’s existing projects in 2014 and estimate ( revenues − costs) (revenues−costs) each year by using the 2014 EBITDA/Sales profitmargin. Calculate EBITDA as EBIT + Depreciation EBIT+Depreciationexpense from the cash flow statement. Determine the annualdepreciation by assuming IBM depreciates these assets by thestraight-line method over a 5-year life. Determine IBM’s tax rateby using the income tax rate in 2014. Calculate the net workingcapital required each year by assuming that the level of NWC willbe a constant percentage of the project’s sales. Use IBM’s 2014NWC/Sales to estimate the required percentage. (Use only accountsreceivable, accounts payable, and inventory to measure workingcapital. Other components of current assets and liabilities areharder to interpret and not necessarily reflective of the project’srequired NWC—for example, IBM’s cash holdings.) To determine thefree cash flow, deduct the additional capital investment and thechange in net working capital each year. Use Excel to determine theNPV of the project with a 12% cost of capital. Also calculate theIRR of the project using Excel’s IRR function. Perform asensitivity 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 isconstant after the first year at a rate of 0%–10%.