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 Net Property, Plant, and Equipment (PPE) at the end of fiscal year 2014. The project will then require an additional investment equal to 10% of the initial investment at the end of the first year of the project, a 5% increase at the end of the second year [Y2=Y1*(1+0.05)], and a 1% increase in the third, fourth, and fifth years. The product is expected to have a life of five years. Firstyear revenues for the new product are expected to be 3% of IBM's total revenue for the fiscal year 2014. 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. 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 you really worked 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 Morningstar.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 by following the framework discussed in class:

EBIT

EBIT(1-t)

+Depreciation

-CapEx

Change in NWC

=Free Cash Flow

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. Before you are ready to calculate operating income (EBIT) you need to estimate EBITDA for the project - assume that the project's profitability will be similar to IBM's existing projects in 2014. Estimate EBITDA/Sales profit margin for IBM in 2014; EBITDA = EBIT+Depreciation (remember, you can find depreciation in the cash flow statement). Apply this profit margin to calculate EBITDA for every year of the project. Note: Do not use EBITDA provided by Mornigstar.com; also, you do not need to estimate any items between Sales and EBITDA on the income statement (COGS, SG&A, etc.); b. Determine the annual depreciation of the CapEx in this project by assuming IBM depreciates these assets by the straight-line method over a 5-year life. c. Determine IBM's tax rate by using the income tax rate in 2014; apply this rate to calculate EBIT(1-t) for all years of the project. 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 2014 NWC/Sales 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.) e. To determine the free cash flow, deduct the additional capital investment and the change in net working capital each year. f. Ignore any salvage value of equipment or working capital at the end of the project.

3. Calculate: a. NPV of the project with a 12% cost of capital b. IRR of the project c. Payback period

4. Perform a sensitivity analysis by varying the project forecasts as follows: a. Suppose first year sales will equal 2%-4% of IBM's revenues. b. Suppose the cost of capital is 10%-15%. Report your finding in 4) in tables and graphs