Question

Company ABC has been doing well, reaching $1.2 million in sales with their current product. Currently, ABC’s costs of production are 50% of sales. Absence of any major change, ABC expects the sales of its current product to stay the same in the foreseeable future. ABC is also considering launching a new product. Designing the new product has already cost $0.5 million in the past two years. The company estimates that it will sell $2.5 million of the new product for the next three years. Production of the new product will end after that. The production cost is expected to be 45% of sales. The introduction of the new product pushes down the prices of the current products which will reduce the sales of the current product by 25%. In order to produce this new product, ABC needs to invest $750,000 in new equipment. The equipment will be depreciated to zero using 3-year straight-line depreciation. The current level of net working capital is $294,000, which is the same as the year before. The new product will require the net working capital to be $405000, $352000, and $294000 in years 1, 2, and 3, respectively. The tax rate is 35% and the project’s cost of capital is 10%. Estimate sales, cogs, depreciation, net working capital, CAPEX, the free cash flow for year 1 for the new product. Note: you only need to fill in the numbers for year 1.  

Sales =

Cogs =

Depreciation =

EBIT =

Tax =

CAPEX =  

Change in Networking capital =

Sunk Cost =

Cannibalization =

Free cash flow =

Answer 1

Refer the table with filled details and explanation:

Note : Sunk cost is the cost bygone cost and therefore not included in Free cash flow. Also, CAPEX is generally considered as outflow in Year 0, and therefore in calculating Year 1 cash flow, its ignored. Depreciation is a non-cash item and therefore is added back in the free cash flow.

Please comment on the answer in case of any doubt in the calculation.