You are evaluating a product for your company. You estimate the sales price of p

Question

You are evaluating a product for your company. You estimate the sales price of product to be $375 per unit and sales volume to be 500 units in year 1; 1,000 units in year 2; and 200 units in year 3. The project has a 3-year life. Variable costs amount to $200 per unit and fixed costs are $100,000 per year. The project requires an initial investment of $175,000 in assets which will be depreciated straight-line to zero over the 3-year project life. The actual market value of these assets at the end of year 3 is expected to be $20,000. NWC requirements at the beginning of each year will be approximately 25% of the projected sales during the coming year. The tax rate is 34% and the required return on the project is 10%. What will the year 2 free cash flow for this project be?

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Year 2 Free Cash Flow = (Sales - Variable Costs - Fixed Costs - Depreciation)*(1-Tax Rate) + Depreciation

Depreciation = Cost/Estimated Life = 175000/3 = 58333.33

Operating Cash Flow = (1000*375 - 1000*200 - 100000 - 58333.33)*(1-34%) + 58333.33 = $69333.33 or $69333

Free Cash Flow = Operating Cash Flow - Change in Working Capital = 69333 - (-75000) = $144333

Option D ($144333) is the correct answer.

Notes:

Change in Working Capital = (200 - 1000)*25%*375 = - 75000

Thanks.

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