This case is a simple capital budgeting exercise that should reinforce your understanding of the

following topics:

Incremental unlevered net income

Free cash flow

Sensitivity analysis and scenario analysis

Introduction

Krolmeister Inc. has developed a new construction chemical that greatly improves the durability

and weatherability of cement-based materials. After spending $500,000 on the research of the

potential market for the new chemical, Krolmeister Inc. is considering a project that requires an initial

investment of $9,000,000 in manufacturing equipment.

The equipment must be purchased before the chemical production can begin. For tax purposes,

the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero

salvage value. For simplicity, however, we will continue to assume that the asset can actually

be used out into the indefinite future (i.e., the actual useful life is effectively infinite).

Krolmeister Inc. anticipates that the sales will be $30,000,000 in the first year (Year 1). They

expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After

that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity.

The cost of goods sold is estimated to be 72% of sales.

The accounting department also estimates that at introduction in Year 0, the new product's

required initial net working capital will be $6,000,000. In future years accounts receivable

are expected to be 15% of the next year sales, inventory is expected to be 20% of the next

year's cost of goods sold and accounts payable are expected to be 15% of the next year's

cost of goods sold.

The selling, general and administrative expense is estimated to be $6,000,000 per year, but

$1 million of this amount is the overhead expense that will be incurred even if the project

is not accepted.

The market research to support the product was completed last month at a cost of $500,000

to be paid by the end of next year.

The annual interest expense tied to the project is $1,000,000.

Krolmeister Inc. has a cost of capital of 20% and faces a marginal tax rate of 30% and an

average tax rate is 20%.

Instructions

I posted an incomplete Excel template for your analysis. You need to figure out how to construct

the pro forma income statements and calculate the incremental unlevered net income. You should

include ONLY the factors that will affect your capital budgeting decision. Revise the template

if necessary.

Note that your analysis should be set up so the assumptions that impact the cash flow estimates

can be easily changed to identify the sensitivity of your calculations to these assumptions.

Questions

1. Use Excel to construct six-year pro forma income statements and calculate the incremental

unlevered net income for the first six years.

2. Calculate six-year projections for free cash flows. Remember to include cash flows from

the income statement and depreciation, changes in net working capital, and capital

expenditures or dispositions.

Hint: You need to calculate the level of net working capital (NWC) and change in NWC.

Pay attention to the timing of NWC.

3. Krolmeister Inc. expects that free cash flow from Year 6 onwards will increase at a constant

rate of 2%/year into the indefinite future. Calculate PV(terminal value that captures the

value of future free cash flows in Year 6 and beyond). That is, calculate the terminal value

first, then find its value in Year 0 (today).

Hint:

a. Assuming the cash flows grow at a constant rate g after Year N+1, then

Year N TV = (Year N+1 CF)/(rg) (from growing perpetuity formula).

where r is discount rate

b. We should discount this Terminal Value back to Year 0.

4. Determine the NPV of the project. Remember to net out any initial cash outflows.