Question

Veridian Dynamics is considering the purchase of a new cloning machine, which will cost $390 million plus an additional $10 million to ship and install. The new machine will replace the existing machine, which has zero book value and could be sold today for $40 million. The new machine will have a 4 year useful life and will be depreciated to zero using the straight line method. The machine will require $10 million worth of spare parts to be pruchased initially and held in inventory for the next 4 years to make sure the machine operates smoothly. It is assumed that these spare parts will be sold at the end of 4 years and the entire $10 million will be recaptured.

The new machine will increase sales by $220 million per year, increase cost of goods sold by $110 million per year, and decrease operating expenses by $10 million per year over the next 4 years. Veridian Dynamics expects to sell the new machine for $80 million at the end of 4 years. Veridian Dynamic's income tax rate is 35% and its cost of capital is 14%.

What is the Annual Free Cash Flow for years 1 through 4?

Answer 1

Computation of annual free cash flow for years 1 through 4					(in $ million)
Year	0	1	2	3	4
Initial Investment	-$400
EBIT		$120	$120	$120	$120
- Taxes		-$42	-$42	-$42	-$42
+ New depreciation		$100	$100	$100	$100
+ Salvage value of new machine					$80
- Tax on salvage of new machine (35%)					-$28
+ Salvage value of old machine	$40
- Tax on salvage of old machine (35%)	-$14
- Investment in spare parts	-$10
+ Recovery of investment in spare parts					$10
Free Cash flow	-$384	$178	$178	$178	$240