Houston oil and gas recently reported $185,250 of sales, $140,500 of operating c
ID: 2808606 • Letter: H
Question
Houston oil and gas recently reported $185,250 of sales, $140,500 of operating costs other than depreciation and 9,250 of depreciation. The company has $35,250 of outstanding bonds that carry a 6.75% interest rate, and its federal plus state income tax rate was 35%. In order to sustain its operations and thus generate future sales and cash flows the firm was required to spend $15,250 to buy new fixed assets and go invest $6,850 in net operating working capital. A. Calculate the firms EBIT and free cash flow and be sure to show the steps taken to arrive at your answers. B. Describe a situation for a company where having a negative FCF is not necessarily a bad occurance. Houston oil and gas recently reported $185,250 of sales, $140,500 of operating costs other than depreciation and 9,250 of depreciation. The company has $35,250 of outstanding bonds that carry a 6.75% interest rate, and its federal plus state income tax rate was 35%. In order to sustain its operations and thus generate future sales and cash flows the firm was required to spend $15,250 to buy new fixed assets and go invest $6,850 in net operating working capital. A. Calculate the firms EBIT and free cash flow and be sure to show the steps taken to arrive at your answers. B. Describe a situation for a company where having a negative FCF is not necessarily a bad occurance. A. Calculate the firms EBIT and free cash flow and be sure to show the steps taken to arrive at your answers. B. Describe a situation for a company where having a negative FCF is not necessarily a bad occurance.Explanation / Answer
Answer A:
Calculation of EBIT:
Free Cash flow = EBIT * (1 - Tax rate) + Depreciation - Net capital expenditure - Increase in Working Capital
Given:
Tax rate = 35%
Net capital expenditure = New fixed assets = $15,250
Increase in Working Capital = Investment in net operating working capital = $6,850
Hence,
Free cash flow = $35,500 * (1 - 35%) + $9,250 - $15,250 - $6,850
=$10,225
Answer B:
Negative FCF is not necessarily a bad occurrence. It is important to analyze the reason for negative cash flow whether it is due to operating or investing activity. For example if a company invests in assets (which are properly evaluated meeting ROI/NPV/IRR criteria as the case may be, thus investing for future growth) and due to such outflows if the FCF is negative, it is not a bad occurrence. In this case, it may result in negative free cash flow in current period due to such investment but in future it will lead to higher cash flows and growth and such investment may be necessary for the growth of the firm.
Sales $185,250 Less, Operating costs other than depreciation $140,500 Less, Depreciation $ 9,250 EBIT $35.500
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