Litton Telephone is a company that provides residential and business phone servi

Question

Litton Telephone is a company that provides residential and business phone service. Litton is considering investing $ 1 billion in a segment of the telecommunication equipment business, and you have been supplied with the following information:

The investment is expected to have a life of 5 years, over which period it will be depreciated straight line to a salvage value of $ 250 million.

The annual revenues are expected to be $ 1.8 billion a year, each year for the next 5 years, and the earnings before interest, taxes, depreciation and allocated G&A is expected to be 25% of revenues in each of those years.

Litton’s selling, general and administrative (S,G and A) annual expenses are currently $ 100 million. If Litton decides to invest in this project, the annual expenses will increase to $ 120 million, and a third of these expenses will be allocated to this project.

The working capital investment (in inventory and accounts receivable) is expected to be 10% of annual revenues, with the investment occurring at the beginning of each year (when such investment is needed).

If this investment is made, Litton will have to buy a new computer to manage inventory in year 2 for $ 200 million. If the investment is not made, Litton would have had to buy a new computer anyway at the end of year 5 for $ 200 million. These cost would be expensed for tax purposes.

When the project ends, the investment in working capital will be fully recouped and the book value of the fixed assets will be recovered.

The cost of capital for this project is 10%.

1. Estimate the incremental after-tax cash flows you will have on this investment each year for the next 5 years. (4 points)
2. Estimate the net present value of this investment.

Explanation / Answer

Solution:

1) Since tax rate is not given in the question i have assumed the tax rate to be 30% and calculated :

Computation of cash flow:

2) To compute the NPV :

In $ millions 1 2 3 4 5 Particulars/Formula Sales 1800 1800 1800 1800 1800 Variable cost 1350 1350 1350 1350 1350 EBIDTA 25% of revenue 450 450 450 450 450 Depreciation 1000million- 250 /5 150 150 150 150 150 General and admin exp 100 100 100 100 100 Annual expense 1/3 of 120 40 40 40 40 40 computer expense 200 Profit 160 -40 160 160 160 Tax 30% 48 -12 48 48 48 Profit after tax 112 -28 112 112 112 CAsh flows = profit+depreciation 262 122 262 262 262

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