# Determine free cash flow, IRR, NPV of a project

Determine the cash flows associated with this project. The operating costs and net working capital requirements are similar to the rest of the company and that depreciation is straightline for capital budgeting purposes.

Dell Computer is considering adding a new product line and needs to determine the net cash flows and NPV of the proposed product line. Development of the new product will require an initial investment equal to 10% of net Property, Plant, and Equipment (PPE) for the fiscal year ended February 3, 2006. The project will then require an additional investment equal to 10% of initial investment after the first year of the project, a 5% increase after the second year, and a 1% after the third, fourth, and fifth years. The project is expected to have a life of five years. First-year revenues for the new product are expected to be 3% of total revenues for Dell's fiscal year ended February 3, 2006. The new product's revenues are expected to grow at 15% for the second year, 10% for the third, and 5% annually for the final two years of the expected life of the project.

1. Obtain Dell's financial statements. Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from MarketWatch (www.marketwatch.com). Enter Dell's ticker symbol and then go to "financials." Export the statements to Excel by right-clicking while the cursor is inside each statement.

2. You are now ready to determine the Free Cash Flow. Compute the Free

Cash Flow for each year using Eq. 7.5 from this chapter:

Free Cash Flow = (Revenues - Cost- Depreciation) x (1-tc)

+ Depreciation - CapEx- ^NWC

Set up the timeline and computation of free cash flow in separate, contiguous columns for each year of the project life. Be sure to make outflows negative and inflow positive.

a. Assume that the project's profitability will be similar to Dell's

Existing projects in 2005 and estimate (revenue-costs) each year by using the 2005 EBITDA/Sales profit margin.

b. Determine the annual depreciation by assuming Dell depreciates these assets by the straight-line method over a 10-year life.

c. Determine Dell's tax rate by using the income tax rate in 2005.

d. Calculate the net working capital required each year by assuming that the level of NWC will be a constant percentage of the project's sales. Use Dell's 2005 NWC/Sales to estimate the required percentage. (Use only accounts receivable, accounts payable, and inventory to measure working capital. Other components of current assets and liabilities are harder to interpret and not necessarily reflective of the project's required NWC- e.g., Dell's cash holding.)

e. To determine the free cash flow, calculate the additional capital investment and the change in net working capital each year.

3. Determine the IRR of the project and the NPV of the project at cost of capital of 12% using the Excel functions. For the calculation of NPV, include cash flows 1 through 5 in the NPV function and then subtract the initial cost (i.e., =NPV (rate, CF1:CF5) + CF0). For IRR, include cash flows zero through five in the cash flow range.

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#### Solution Summary

The solution explains how to determine free cash flow, IRR and NPV of a project

Compute free cash flow, initial outlay, terminal cash flow, NPV, IRR. Discuss project risk, CAPM, simulations and sensitivity analysis.

Using data in the attached excel file, respond to these:

Should the company focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows,

incremental profits, total free cash flows, or total profits?

b.

How does depreciation affect free cash flows?

c.

How do sunk costs affect the determination of cash flows?

d.

What is the projects initial outlay?

e.

What are the differential cash flows over the projects life?

f.

What is the terminal cash flow?

g.

Draw a cash flow diagram for this project?

h.

What is its net present value?

i.

What is its internal rate of return?

j.

Should the project be accepted? Why or why not?

k.

In capital budgeting, risk can be measured from three perspectives. What are those three measures of a projects risk?

l.

According to CAPM, which measurements of a projects risk is relevant? What complications does reality introduce into the CAPM view of risk, and what does that

mean for our view of the relevant measure of a projects risk?

m.

Explain how simulation works. What is the value in using a simulation approach?

n.

What is sensitivity analysis and what is its purpose?