Consider a firm in an industry in which technology improvements are constantly l

Question

Consider a firm in an industry in which technology improvements are constantly lowering its cost of physical capacity. On average, the cost to acquire a unit of physical capacity drops by about 15% per year and is expected to continue to do so for the foreseeable future. Fixed assets are depreciated on a straight-line basis over five years and, if not for the dropping cost of capacity, would represent a reasonable estimate of the amount of capital investment necessary to maintain capacity at the existing level.

Construct formulas that could be used in a free cash flow forecast model to determine the amount of depreciation and capital expenditures in a given year. Assume that sales have already been forecasted and are represented by SALESt.

Explanation / Answer

Assumptions

Let Sales for Year t is forecasted as SALESt.

pm is the profit margin (EBIT)

T is the tax rate

D represent total debt and r represent cost of debt.

E represent total Equity and CA and CL are current Assets and Current Liabilities respectively. (CA-CL)0 is working capital in initial year and (CA-CL)t is working capital in year t

p is dividend payment.

Let NF be the net Fixed assets and are depreciated at straight line method in 5 years. Cost of replacement of Fixed Assets decreases by 15% every year for foreseeable future.

Capital expenditure represents additions to Fixed Assets

The firm does not have any other assets or investments

The free cash flows can be calculated using the formula

Free Cash Flow = Net Income + Depreciation & Amortization + Interest (1-T) + Change in Working Capital – Capital Expenditure

Net Income = Sales * pm = SALESt * pm

Depreciation = Fixed Assets * 0.20 = 0.2 NF

Interest = D * r

Change in working capital = (CA-CL)t – (CA-CL)0

Capital Expenditure = 0.2 NF * (1-drecrease in prices of fixed assets) = 0.2 NF * (1-.15)

                                     = 0.2 NF * 0.85 = 0.17 * NF

Free Cash Flows of the Firm = SALESt * pm + D*r (1-T) + 0.2 NF + (CA-CL)t –(CA-CL)0 – 0.17* NF

FCF = SALESt * pm + 0.03 NF + D*r(1-T) +(CA-CL)t –(CA-CL)0

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