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.

Development of the new system will initially require an initial capital expenditure equal to 10% of IBM's Property, Plant, and Equipment 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 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 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 thecompany and that depreciation is straight-line 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:

1. Obtain IBM's financial statements. (If youreallyworked for IBM you would already have this data, but at least you won't get fired if your analysis is off target.) Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from Yahoo! Finance (finance.yahoo.com). Enter IBM's ticker symbol and then go to "financials."
2. You are now ready to estimate the Free Cash Flow for the new product. Compute the Free Cash Flow for each year.

Set up the timeline and computation of 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(revenuescosts) (revenuescosts)each year by using the latest EBITDA /Sales profit margin. Calculate EBITDA asEBIT+DepreciationEBIT+Depreciationexpense 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 project's required NWCfor example, IBM's cash holdings.)

3 To determine the free cash flow, deduct the additional capital investment and thechangein net working capital each year.

4 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.

Some notes:

#1 - provide the financial statements as instructed

#2 - to derive the free cash flow, you must first derive the answers to 2a through 2e

2a: Profit margin is calculated by going to the base year income statement and taking Operating Profit Before Interest, Taxes, and Depreciation/Amortization and dividing the amount by Total Revenues. The answer should be expressed in terms of a percent. Take the percentage out two decimal places (e.g. 9.78% - and I'm just making up that number).

Revenues will grow in years two through five by the percentages cited in the introductory paragraphs for the data case. However, the profit margin percentage will remain the same as you calculated above. That will enable you to calculate operating income for years one through five.

2b: To calculate capital expenditures and depreciation expense in years one through five, you must first find the "Net Fixed Assets" amount from the base year balance sheet. Capital expenditures will increase over that amount by the percentages cited in the introductory paragraphs. These items will be depreciated straight-line over 5 years. Depreciation expense for year one is calculated on the net fixed assets at the end of year zero, depreciation for year two is calculated on net fixed assets at the end of year one, etc. Keep in mind that each year's capital expenditures are added to the previous year's net fixed assets to derive the new amount for fixed assets.

2c: This one is easy. Just go to the base year income statement and take the Income Tax amount and divide it by the Income Before Tax (EBT) amount. Take the percentage out to two decimal places (e.g. 21.54% - and I'm making up that number).

2d: This is more difficult, and the textbook authors get even for giving you an easy calculation in 2c. The first thing you have to do is, using the base year income statement and balance sheet, determine the percentages of 1) current assets to sales and 2) current liabilities to sales. The narrative in 2d tells you to use only Accounts Receivable and Inventory for your current assets, and only Accounts Payable for your current liabilities. For example, let's make up some numbers and say that the percentage of current assets to sales is 11.66% and the percentage of current liabilities to sales is 18.43%.

Once you determine those percentages, then you take the year one revenues times (11.66% minus 18.43%). Remember, I made up those percentages. The result in this example will give you a negative number, and that will be your net working capital (NWC) for year one. Then you go through the same calculations for years two through five, using the same percentages of CA/Sales and CL/Sales. Remember to show the "change" in NWC from year to year. For example, if the NWC is -$100 in year one and -$119 in year two, then the change in NWC is -$19. And yes, I am making up those numbers, too.