You have just been hired by Internal Business Machines Corporation (IBM) in their capital budgeting division. Your first assignment is to determine the free cash flows and NPV of a proposed new type of tablet computer similar in size to an iPad but with the operating power of a high-end desktop system.
Point 2: The product is expected to have a life of five years.
Point 3: First-year revenues for the new product are expected to be 3% of IBM’s total revenue for the latest fiscal year using fiscal year 2019 or data from 12/31/2019.
Point 4: The new product’s revenues are expected to grow at 15% for the second year then 10% for the third and 5% annually for the final two years of the expected life of the project.
Your job is to determine the rest of the cash flows associated with this project. Your boss has indicated that the operating costs and net working capital requirements are similar to the rest of the company (implying the project will have the same ratio of EBITDA to sales and working capital to sales) and that depreciation is straight-line (over 5 years) for capital budgeting purposes. Since your boss hasn’t been much help (welcome to the “real world”!), here are some tips to guide your analysis:
Point 6: Determine the annual depreciation by assuming IBM depreciates these assets by the straight-line method over a five-year life (i.e., depreciate the ‘cost of the new system’ in Point 1).
Point 7: Determine IBM’s tax rate by using the current U.S. federal corporate income tax rate (Use an estimated 21% for the corporate tax rate).
Point 8: In year 1, you are going to increase NWC using the NWC / Sales ratio for IBM in 12/31/2019 using only A/R, A/P, and inventory to measure NWC (use Table 8.3 and 8.4 as a guide for how to bring the increase in NWC into your FCF estimate in year one and take it back out in year 5—for simplicity purposes we are going to assume that NWC remains fixed in years 2 through 4 and then it is recaptured in year 5).
Point 9: To determine the free cash flow, deduct the additional capital investment and the change in net working capital each year (note: using information from Point 8, the NWC will only change in years 1 and 5—see Table 8.3 line item 12 and Table 8.4 as an example).
Point 10: Use Excel to determine the NPV of the project with a 12% cost of capital. Also calculate the IRR of the project using Excel’s IRR function.
Point 11: Perform a sensitivity analysis by varying the project forecasts as follows:
a. Suppose first year sales will equal 2%–4% of IBM’s revenues.
b. Suppose the cost of capital is 10%–15%.
c. Suppose revenue growth is constant after the first year at a rate of 0%–10%
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