5. Now let\'s look at a different investment opportunity: Our timber company is

Question

5. Now let's look at a different investment opportunity: Our timber company is thinking about planting truffles in one of its forests. It has spent $25,000 researching the local truffle market and believes that if it spends $500,000 today, it will be able produce 1,000 pounds truffles per year for the next 50 years At present, truffles can be sold for $300 per pound, suggesting that this strategy would produce revenues of $300,000 per year. The company believes that it could harvest the truffles at a fixed cost of ($50,000) per year, and does NOT expect there to be any depreciation or changes working capital as a result of this investment. The required return on this investment is 10%, and the tax rate is expected to be 20%. a) How much free cash flow will this project produce for the company each year, and what is its payback period? nial cost SD00,000 evenue300,ooo Estimate the breakeven cash flow of this project. How many pounds of truffles would we have to harvest each year in order to produce this? b)

Explanation / Answer

a)Free cash flows each year = (Revenue-Costs)*(1-Tax)

=(300000-50000)*(1-0.2)

=$200,000

Initial cost= $500,000

Since $ 25000 spent on research is sunk cost

Amount recovered in 2 years = $400,000

Payback = 2 years + (500000-400000)/200000

= 2.5 years

b) Annuity required to cover initial cost = 500000* (A/P,10%,50)

= 500000* 0.1009 = $50450

Pre tax FCF required each year = 50450*100/80 = 63062.5

Revenues required = 63062.5+ 50000 = 113062.5

Volume of truffles to be harvested= 113062.5/ 300 = 376.875

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