Question

The firm Gelati-Banking (GB) is considering a project with the following characteristics.

- Sales will be $100 MM for sure in the first year and grow 10% in the second year; thereafter, the long term growth rate is 3%. Gross Profit Margin (Gross Profit over Sales) will be 20%.

- Depreciation will be $10 MM each year for the next two years. The Corporate Tax Rate is 40%.

- Working Capital held for the project will have to be 10% of sales. Additional CAPX each year will be $11MM in year 1 and $12 MM in year 2.

- All cash flows defined here are deterministic and will go on indefinitely. Assume that 1) Everything grows at 3% per year from year 2 onwards to infinity; and 2) The cash flow stream that goes from time 0 on indefinitely is similar in nature to a long term treasury bond.

- Interest rates are as follows: 3-month t-bill is 3%, the 2 year treasury is 4% and the long bond (30-year) is trading at 5% per year.

What would the investment need to be for this project to be breakeven (ignoring depreciation effects of the investment)?

Answer 1

Cash flows will be as follows:

Particulars	Year 1($ in MM)	Year 2
Sales	100	110
Gross Profit(Sales*20%)	20	22
Less:Depreciation	-10	-10
Net Profit	10	12
Less: Tax @40%	-4	-4.8
Net Profit After Tax	6	7.2
Add: Depreciation(Non-Cash)	10	10
Net Income	16	17.2
Less: Fixed Cap Investment	-11	-12
Less: Working Cap Inv(10% of Sales)	-10	-1 (11-10)
Free Cash Flow	-5	4.2

g = 3%

r= 5%

Project value = 4.2(1+0.03)/(0.05 - 0.03)= 4.326/0.02 = 216.3

Break-Even Investment value = [-5/(1+0.05)] + [(4.2+216.3)/(1+0.05)^2]

= -4.76 + 200

= $195.24 MM