Forecasting cash flows

You are the financial manager of ABC, the well-known widget pro- ducer. You have the project of an investment into a new model of widgets, and you have to forecast the free cash flows generated by the project. You are now at the beginning of year 0, and the project will generate cash flows until the end of year 5. This is the data you have:

The initial investment (the purchase of new equipment) is $ 4,000,000. The investment will be made at the end of year 0.

The production of the new widget will begin in year 1. It is anticipated that ABC will be able to sell 1000 widgets in year 1, when widgets are first introduced, then 4000 widgets in years 2 to 4, and finally 3000 widgets in year 5, the last year this type of widgets will be produced. The price per widget will be $ 1500 in years 1 to 4, then $ 1,000 in year 5, as competition catches up with ABC and consumers switch to other products. (Assume all cash flows in years 0 to 5 occur at the end of the respective years).

The direct cost per new widget will be $ 500 in all five years of production.

The production of the new-type widgets will lead to selling costs of $ 200,000 every year from year 1 to year 5.

The firm will also launch a marketing campaign in year 0 to promote the product. The cost of the campaign is $ 500,000, and is added to the usual selling expenses.

The initial investment will be depreciated using straight-line depreciation (i.e., equal amounts each year) for 5 years from year 1 to year 5. The salvage value of the equipment is zero.

The production of the new widgets will take place in a previ- ously unused building belonging to ABC. The market rental income on such a building is $ 200,000 per year. The building will already be used in year 0. (If necessary, rent expenses are includes in selling, general and administrative).

The equipment used in the project requires maintenance, and the monthly maintenance costs are estimated at $ 2000 per month.

The salaries of administrative and sales personnel involved in the project (including related charges) are estimated at $ 20,000 per month. They are employed starting from year 1, and they stop working for the project at the end of year 5.

The introduction of the new model of widgets will increase the sales an existing model of a widget cartridge ABC already produces. Every new widget will be sold with two cartridges. The sale price of a cartridge is $50, and the cost of producing one is $40.

At the same time, the introduction of the new widget model will reduce the sales of ABCs older widget model. Right now ABC has annual sales of $2,000,000 for the old model, and those sales are declining at 2% per year. With the new widget model on the market, sales of the old widget are expected to be 20% lower. The direct costs of producing the old widget model are equal to 80% of sales. The old model is scheduled to come out of production in any case at the end of year 4. When production stops, the equipment used to produce the old widgets will be retired and sold for scrap. ABC expects to make $1,500,000 after tax from selling the old equipment in year 4.

The firm has spent $ 3,000,000 on research and development for the new widget. If the project is adopted, it will also spend $ 100,000 per year on research and development every year from 0 to 5.

The sales of the new widget model will lead to an increase in accounts receivable, accounts payable and inventory. Accounts payable generated by the project will be 20% of the direct costs (COGS) of producing the new widget every year. Accounts receivable generated by the new project will be 20% of the new widget sales generated by the project in each given year. Inventory (raw materials and unfinished products) generally represent 15% of ABCs sales of new widgets. After the end of the project, in year 6, the firms net working capital will return to previous levels.

The corporate income tax is 25%. The project is part of a large profitable company, with many other products.

The project is managed as part of a large and profitable tax entity, and it is financed exclusively via equity.

What are the firms free cash flows in years 0 to 5?

Assume the cost of capital for this type of project is 12% per year. What is the net present value of the project?

What is the payback period of the project? What is the internal rate of return of the project?