Question

A beauty product company is developing a new fragrance named Happy Forever. There is a probability of 0.50 that consumers will love Happy Forever, and in this case, annual sales will be 1.00 million bottles; a probability of 0.36 that consumers will find the smell acceptable and annual sales will be 218,000 bottles; and a probability of 0.14 that consumers will find the smell unpleasant and annual sales will be only 53,000 bottles. The selling price is $36, and the variable cost is $8 per bottle. Fixed production costs will be $1.06 million per year, and depreciation will be $1.20 million. Assume that the marginal tax rate is 40 percent.

What are the expected annual incremental after-tax free cash flows from the new fragrance?

Answer 1

Free cash flow = (Number of bottles sold*(Price per unit - Variable cost per unit) - Fixed cost)*(1-Tax rate) + (Depreciation*Tax rate)

Expected free cash flow = sum of (probability*free cash flow)

Calculation of free cash flow is, as follows:

Expected free cash flow = (0.50*16,644,000) + (0.36*3,506,400) + (0.14*734,400) = 9,687,120 (Answer)