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 (PPE) at the end of fiscal year 2017. 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 fiscal year 2017. 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 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 Yahoo! Finance (finance.yahoo.com). Enter IBM's ticker symbol and then go to financials." 1. 2. You are now ready to estimate the Free Cash Flow for the new product. Compute the Free Cash Flow for each year using Eq. 8.5: 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 Assume that the project's profitability will be similar to IBM's existing projects in 2017 and estimate (revenues-costs) (revenues-costs) each year by using the 2017 EBITDA/Sales profit margin. Calculate EBITDA as EBITDepreciation expense from the cash flow statement. a. b. Determine the annual depreciation 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 2017. 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 2017 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 NWC-for example, IBM's cash holdings.) To determine the free cash flow, deduct the additional capital investment and the change in net working capital each year. e. 3. 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 4. Perform a sensitivity analysis by varying the project forecasts as follows Suppose first year sales will equal 2%-4% of IBM's revenues suppose the cost of capital is 10%-15% Suppose revenue growth is constant after the first year at a rate of 0%-10% a. b. C. Revenue 12/31/2017 12/31/2016 12/31/2015 12/31/2014 79,139,000 42,913,000 36,226,000 79,919,000 41,624,000 38,295,000 81,741,000 41,057,000 40,684,000 92,793,000 46,386,000 46,407,000 Total Revenue Cost of Revenue Gross Profit Operating Expenses Research Development 5,787,000 5,751,000 5,247,000 5,437,000 Selling General and Administrative 19,986,000 19,977,000 19,589,000 21,549,000 Non Recurring 1,445,000 67,241,000 11,898,000 1,604,000 65,748,000 14,171,000 Others -669,000 65,224,000 16,517,000 -708,000 72,664,000 20,129,000 Total Operating Expenses Operating Income or Loss Income from Continuing operations Total Other Income/Expenses Net Earnings Before Interest and Taxes Interest Expense -498,000 11,898,000 -615,000 11,400,000 5,642,000 1,841,000 14,171,000 -630,000 12,330,000 449,000 572,000 16,517,000 -468,000 15,945,000 2,581,000 144,000 20,129,000 -484,000 19,985,000 4,234,000 Income Before Tax Income Tax Expense Minority Interest 131,000 146,000 162,000 146,000 Net Income From Continuing Ops 5,758,000 11,881,000 13,364,000 15,751,000 Non-recurring Events Discontinued Operations Extraordinary Item:s Effect Of Accounting Changes Other Items 5,000 9,000 -174,000 -3,729,000 Net Income Net Income 5,753,000 11,872,000 13,190,000 12,022,000 Preferred Stock And Other Adjustments Net Income Applicable To Common Shares 5,753,000 11,872,000 13,190,000 12,022,000 Period Ending 12/31/2017 12/31/2016 12/31/2015 12/31/2014 Current Assets 11,972,000 608,000 9,909,000 1,583,000 184,000 49,735,000 581,000 11,116,000 36,788,000 3,742,000 7,826,000 701,000 10,239,000 1,553,000 532,000 43,889,000 659,000 10,830,000 36,199,000 4,688,000 7,686,000 508,000 9,534,000 1,551,000 293,000 42,504,000 1,131,000 10,727,000 32,021,000 3,487,000 Cash And Cash Equivalents 8,476,000 Short Term Investments Net Receivables 11,996,000 Inventory 2,103,000 Other Current Assets 746,000 47,377,000 1,222,000 10,771,000 30,556,000 3,104,000 Total Current Assets Long Term Investments Property Plant and Equipment Goodwill Intangible Assets Accumulated Amortization Other Assets 13,844,000 4,862,000 125,356,000 12,184,000 5,224,000 117,470,000 10,612,000 4,822,000 110,495,000 13,132,000 6,675,000 117,271,000 Deferred Long Term Asset Charges Total Assets Current Liabilities Accounts Payable Short/Current Long Term Debt Other Current Liabilities 6,451,000 5,215,000 16,451,000 6,209,000 6,239,000 14,693,000 36,275,000 34,663,000 28,140,000 1,496,000 146,000 6,028,000 5,271,000 14,281,000 34,269,000 33,431,000 28,371,000 1,626,000 162,000 6,864,000 4,601,000 17,393,000 39,581,000 34,991,000 30,685,000 1,524,000 146,000 Total Current Liabilities 37,363,000 39,871,000 30,397,000 1,536,000 131,000 Long Term Debt Other Liabilities Deferred Long Term Liability Charges Minority Interest Negative Goodwill Total Liabilities 107,631,000 99,078,000 96,071,000 105,257,000 Stockholders' Equity Misc. Stocks Options Warrants Redeemable Preferred Stock Preferred Stock Common Stock Retained Earnings Treasury Stock Capital Surplus Other Stockholder Equity Total Stockholder Equity Net Tangible Assets 54,566,000 153,126,000 -190,098,000 53,935,000 152,759,000 -188,448,000 53,262,000 146,124,000 185,124,000 52,666,000 137,793,000 -178,591,000 26,591,000 17,594,000 22,936,000 -29,398,000 18,246,000 22,641,000 29,606,000 14,262,000 21,246,000 -27,876,000 11,868,000 21,792,000 Period Ending 12/31/2017 12/31/2016 12/31/2015 12/31/2014 Net Income 5,753,000 11,872,000 13,190,000 12,022,000 Operating Activities, Cash Flows Provided By or Used In Depreciation Adjustments To Net Income Changes In Accounts Receivables Changes In Liabilities Changes In Inventories 4,541,000 -383,000 1,297,000 47,000 18,000 5,451,000 16,724,000 4,381,000 526,000 712,000 197,000 -14,000 3,855,000 2,406,000 812,000 81,000 133,000 3,222,000 17,255,000 4,492,000 2,120,000 1,270,000 -456,000 39,000 2,541,000 16,868,000 Changes In Other Operating Activities 462,000 Total Cash Flow From Operating Activities 17,084,000 Investing Activities, Cash Flows Provided By or Used In Capital Expenditures Investments 3,579,000 231,000 1,000 -8,159,000 3,740,000 155,000 1,000 -3,001,000 3,229,000 -3,567,000 225,000 1,000 -10,976,000 1,054,000 Other Cash flows from Investing Activities Total Cash Flows From Investing Activities -7,096,000 Financing Activities, Cash Flows Provided By or Used In Dividends Paid -5,506,000 -5,256,000 -4,897,000 -4,265,000 Sale Purchase of Stock 2,763,000 -1,000 5,917,000 1,783,000 1,000 -15,452,000 Net Borrowings 3,447,000 1,000 -6,418,000 19,000 1,000 -9,413,000 Other Cash Flows from Financing Activities Total Cash Flows From Financing Activities Effect Of Exchange Rate Changes 937,000 51,000 473,000 -655,000 Change In Cash and Cash Equivalents 4,146,000 140,000 790,000 -2,240,000 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 (PPE) at the end of fiscal year 2017. 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 fiscal year 2017. 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 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 Yahoo! Finance (finance.yahoo.com). Enter IBM's ticker symbol and then go to financials." 1. 2. You are now ready to estimate the Free Cash Flow for the new product. Compute the Free Cash Flow for each year using Eq. 8.5: 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 Assume that the project's profitability will be similar to IBM's existing projects in 2017 and estimate (revenues-costs) (revenues-costs) each year by using the 2017 EBITDA/Sales profit margin. Calculate EBITDA as EBITDepreciation expense from the cash flow statement. a. b. Determine the annual depreciation 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 2017. 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 2017 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 NWC-for example, IBM's cash holdings.) To determine the free cash flow, deduct the additional capital investment and the change in net working capital each year. e. 3. 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 4. Perform a sensitivity analysis by varying the project forecasts as follows Suppose first year sales will equal 2%-4% of IBM's revenues suppose the cost of capital is 10%-15% Suppose revenue growth is constant after the first year at a rate of 0%-10% a. b. C. Revenue 12/31/2017 12/31/2016 12/31/2015 12/31/2014 79,139,000 42,913,000 36,226,000 79,919,000 41,624,000 38,295,000 81,741,000 41,057,000 40,684,000 92,793,000 46,386,000 46,407,000 Total Revenue Cost of Revenue Gross Profit Operating Expenses Research Development 5,787,000 5,751,000 5,247,000 5,437,000 Selling General and Administrative 19,986,000 19,977,000 19,589,000 21,549,000 Non Recurring 1,445,000 67,241,000 11,898,000 1,604,000 65,748,000 14,171,000 Others -669,000 65,224,000 16,517,000 -708,000 72,664,000 20,129,000 Total Operating Expenses Operating Income or Loss Income from Continuing operations Total Other Income/Expenses Net Earnings Before Interest and Taxes Interest Expense -498,000 11,898,000 -615,000 11,400,000 5,642,000 1,841,000 14,171,000 -630,000 12,330,000 449,000 572,000 16,517,000 -468,000 15,945,000 2,581,000 144,000 20,129,000 -484,000 19,985,000 4,234,000 Income Before Tax Income Tax Expense Minority Interest 131,000 146,000 162,000 146,000 Net Income From Continuing Ops 5,758,000 11,881,000 13,364,000 15,751,000 Non-recurring Events Discontinued Operations Extraordinary Item:s Effect Of Accounting Changes Other Items 5,000 9,000 -174,000 -3,729,000 Net Income Net Income 5,753,000 11,872,000 13,190,000 12,022,000 Preferred Stock And Other Adjustments Net Income Applicable To Common Shares 5,753,000 11,872,000 13,190,000 12,022,000 Period Ending 12/31/2017 12/31/2016 12/31/2015 12/31/2014 Current Assets 11,972,000 608,000 9,909,000 1,583,000 184,000 49,735,000 581,000 11,116,000 36,788,000 3,742,000 7,826,000 701,000 10,239,000 1,553,000 532,000 43,889,000 659,000 10,830,000 36,199,000 4,688,000 7,686,000 508,000 9,534,000 1,551,000 293,000 42,504,000 1,131,000 10,727,000 32,021,000 3,487,000 Cash And Cash Equivalents 8,476,000 Short Term Investments Net Receivables 11,996,000 Inventory 2,103,000 Other Current Assets 746,000 47,377,000 1,222,000 10,771,000 30,556,000 3,104,000 Total Current Assets Long Term Investments Property Plant and Equipment Goodwill Intangible Assets Accumulated Amortization Other Assets 13,844,000 4,862,000 125,356,000 12,184,000 5,224,000 117,470,000 10,612,000 4,822,000 110,495,000 13,132,000 6,675,000 117,271,000 Deferred Long Term Asset Charges Total Assets Current Liabilities Accounts Payable Short/Current Long Term Debt Other Current Liabilities 6,451,000 5,215,000 16,451,000 6,209,000 6,239,000 14,693,000 36,275,000 34,663,000 28,140,000 1,496,000 146,000 6,028,000 5,271,000 14,281,000 34,269,000 33,431,000 28,371,000 1,626,000 162,000 6,864,000 4,601,000 17,393,000 39,581,000 34,991,000 30,685,000 1,524,000 146,000 Total Current Liabilities 37,363,000 39,871,000 30,397,000 1,536,000 131,000 Long Term Debt Other Liabilities Deferred Long Term Liability Charges Minority Interest Negative Goodwill Total Liabilities 107,631,000 99,078,000 96,071,000 105,257,000 Stockholders' Equity Misc. Stocks Options Warrants Redeemable Preferred Stock Preferred Stock Common Stock Retained Earnings Treasury Stock Capital Surplus Other Stockholder Equity Total Stockholder Equity Net Tangible Assets 54,566,000 153,126,000 -190,098,000 53,935,000 152,759,000 -188,448,000 53,262,000 146,124,000 185,124,000 52,666,000 137,793,000 -178,591,000 26,591,000 17,594,000 22,936,000 -29,398,000 18,246,000 22,641,000 29,606,000 14,262,000 21,246,000 -27,876,000 11,868,000 21,792,000 Period Ending 12/31/2017 12/31/2016 12/31/2015 12/31/2014 Net Income 5,753,000 11,872,000 13,190,000 12,022,000 Operating Activities, Cash Flows Provided By or Used In Depreciation Adjustments To Net Income Changes In Accounts Receivables Changes In Liabilities Changes In Inventories 4,541,000 -383,000 1,297,000 47,000 18,000 5,451,000 16,724,000 4,381,000 526,000 712,000 197,000 -14,000 3,855,000 2,406,000 812,000 81,000 133,000 3,222,000 17,255,000 4,492,000 2,120,000 1,270,000 -456,000 39,000 2,541,000 16,868,000 Changes In Other Operating Activities 462,000 Total Cash Flow From Operating Activities 17,084,000 Investing Activities, Cash Flows Provided By or Used In Capital Expenditures Investments 3,579,000 231,000 1,000 -8,159,000 3,740,000 155,000 1,000 -3,001,000 3,229,000 -3,567,000 225,000 1,000 -10,976,000 1,054,000 Other Cash flows from Investing Activities Total Cash Flows From Investing Activities -7,096,000 Financing Activities, Cash Flows Provided By or Used In Dividends Paid -5,506,000 -5,256,000 -4,897,000 -4,265,000 Sale Purchase of Stock 2,763,000 -1,000 5,917,000 1,783,000 1,000 -15,452,000 Net Borrowings 3,447,000 1,000 -6,418,000 19,000 1,000 -9,413,000 Other Cash Flows from Financing Activities Total Cash Flows From Financing Activities Effect Of Exchange Rate Changes 937,000 51,000 473,000 -655,000 Change In Cash and Cash Equivalents 4,146,000 140,000 790,000 -2,240,000
