You have just been hired by International 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.
Development of the new system will require an initial capital expenditure equal to 1% of IBM’s Property, Plant, and Equipment (PPE) at the end of the latest fiscal year for which data is available. The project will then require an additional investment equal to 10% of the initial investment in the first year of the project, and 5% of the initial investment in the second year. The product is expected to have a life of five years. First-year revenues for the new product are expected to be 5% of IBM’s total revenue for the latest fiscal year for which data is available. 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 and that depreciation is straight-line for capital budgeting purposes 

1. Obtain IBM’s financial statements.

2. You are now ready to determine the free cash flow. Compute the free cash flow for each year using Eq.9.6 from this chapter:

Set up the timeline and computation of the free cash flow in separate, contiguous columns for each year of the project life. Be sure to make outflows negative and inflows positive.

a. Assume that the project’s profitability will be similar to IBM’s existing projects in the latest fiscal year and estimate (revenues − costs) each year by using the latest EBITDA/Sales profit margin. Calculate EBITDA as EBIT + Depreciation and Amortization expense from the cash flow statement.

b. Determine the annual depreciation by assuming IBM depreciates these assets by the straight-line method over a five-year life.

c. Determine IBM’s tax rate by using the current U.S. federal corporate income tax rate.

d. Calculate the net working capital required each year by assuming that the level of NWC will be a constant percentage of the project’s sales. Use IBM’s NWC/Sales for the latest fiscal year to estimate the required percentage. (Use only accounts receivable, accounts payable, and inventory to measure working capital. Other components of current assets and liabilities are harder to interpret and not necessarily reflective of the required of required NWC for this project.)

e. To determine the free cash flow, deduct the additional capital investment and the change in net working capital each year.

3.Calculate the NPV of the project with a 12% cost of capital. Next, calculate the IRR of the project.

4.Perform a sensitivity analysis by varying the project forecasts as follows:

a. Suppose first year sales will equal 4%–6%of IBM’s revenues.

b. Suppose the cost of capital is 10%–15%.

c. Suppose revenue in the first year ranges from 3% to 7% of IBM’s total revenue.