Question

​(Determining relevant cash​ flows)  Landcruisers Plus​ (LP) has operated an online retail store selling​ off-road truck parts. As the name​ implies, the firm specializes in parts for the venerable Toyota FJ40 that is known throughout the world for its durability and offroad prowess. The fact that Toyota stopped building and exporting the FJ40 to the U.S. market in 1982 meant that FJ40 owners depended more and more on​ re-manufactured parts to keep their beloved​ off-road vehicles running. More and more FJ40 owners are replacing the original inline​ six-cylinder engines with a modern​ American-built engine. The engine replacement requires mating the new engine with the Toyota drive train.

​LP's owners had been offering engine adaptor kits for some time but have recently decided to begin building their own units. To make the adaptor kits the firm would need to invest in a variety of machine tools costing a total of

​$800 comma 000800,000.

​LP's management estimates that they will be able to borrow

​$340 comma 000340,000

from the​ firm's bank and pay

88

percent interest. The remaining funds would have to be supplied by​ LP's owners.

The firm estimates that they will be able to sell​ 1,000 units a year for

​$1 comma 3501,350

each. The units would cost

​$1 comma 0001,000

each in cash expenses to produce​ (this does not include depreciation expense of

​$80 comma 00080,000

per year or interest expense of

​$27 comma 20027,200​).

After all​ expenses, the firm expects earnings before interest and taxes of

​$270 comma 000270,000.

The firm pays taxes equal to

3838

​percent, which results in net income of

​$140 comma 200140,200

per year over the

1010​-year

expected life of the equipment.

a.  What is the annual free cash flow LP should expect to receive from the investment in year 1 assuming that it does not require any other investments in either capital equipment or working capital and the equipment is depreciated over a

1010​-year

life to a zero salvage and book​ value? How should the financing cost associated with the

​$340 comma 000340,000

loan be incorporated into the analysis of cash​ flow?

b.  If the​ firm's required rate of return for its investments is

1414

percent and the investment has a

1010​-year

expected​ life, what is the anticipated NPV of the​ investment?

Answer 1

a. Annual Free Cash Flow in year 1

= EBIT(Earnings before Interest and Tax)  – (EBIT x tax%) + depreciation expense

Calculation for EBIT:

Revenue = 1000 * 1350 = 1,350,000

Less: Cost of Goods Sold = 1000*1000 = -1,000,000

Gross Profit = = 350,000

Less : Depreciation = -80,000

EBIT = 270,000

Cash flow at year 1 = EBIT - ( EBIT - Tax % ) + Depreciation

= $ { 270,000 - ( 270,000 * 38% ) } + ( 800,000 ) / 10

= $ ( 270,000 - 102,600 ) + $ 80,000

   = $ 167,400 + $ 80,000= $ 167,400 + $ 80,000 = $ 247,400

Financing cost associated with the ​$340,000 loan should not be incorporated into the analysis of cash​ flow,

b. NPV = Cash Flow / (1+i) ^t - Initial Investment

Initial Investment = Cost of Equipment

i = 14 %

t = 10