Data Case

You have 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. Development of the new system will initially require an initial capital expenditure equal to 10% of IBMs 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 in-vestment after the first year of the project, a 5% increase after the second year, and a 1% increase after the third, fourth, and fifth years. The product is expected to have a life of five years. First-year revenues for the new product are expected to be 3% of IBMs total revenue for the latest fiscal year for which data is available. The new products 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. (8 points) Compute the Free Cash Flow for each year.

a. Assume that the projects profitability will be similar to IBMs 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 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. Calculate the net working capital required each year by assuming that the level of NWC will be a constant percentage of the projects sales. Use IBMs 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 projects required NWCfor example, IBMs cash holdings.)

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

2. (4 points) Use Excel to determine the NPV of the project with a 12% cost of capital. Also calculate the IRR of the project using Excels IRR function.

3. (6 points) Perform a sensitivity analysis by varying the project forecasts as follows:

a. Suppose first year sales will equal 2%4% of IBMs 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%