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%.

A. SALES

B. COGS
C. Depcriation

D. EBIT
E> TAX
F> CAPEX
G> NWC
H> Sunk Cost

I> Cannibalization

J.FCF

Answer 1

Please note that the sunk cost is not considered for calculating the free cash flow. Also, CAPEX is an expense incurred in year 0 and therefore not included in the year 1 free cash flow calculation.

With respect to depreciation, it is added back to the free cash flow in the end because it is a non-cash expenditure and shall not impact the cash flow. It was previsously reduced for taxation purpose, later added back.