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# Incremental Earnings and Free Cash Flows

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Elmdale Enterprises is deciding whether to expand its production facilities. Although long term cash flows are difficult to estimate, management has projected the following cash flows for the first two year ( in millions of dollars):

Year 1 Year 2

Revenues 125 160
Cost of goods sold& operating expense,other depreciation 40 60
Depreciation 25 36
Increase in net working capital 5 8
Capital Expenditures 30 40
Marginal corporate tax rate 35% 35%
a) What are the incremental earnings for this project for years 1 & 2?
b) What are the free cash flows for this project for the first two years?

#### Solution Preview

Generally, incremental earnings is the net increase in net income from making an investment, while free cash flow is the effect on cash (increases and decreases) from making an investment.

a) What are the incremental earnings for this project for years 1 & 2?

Year 1 Year 2

Revenues ...

#### Solution Summary

This solution illustrates how to compute incremental earnings and free cash flows.

\$2.19

## Annual Incremental Earnings

1. Daily Enterprises is purchasing a \$9.5 million machine. It will cost \$45,000 to transport and install the machine. The machine has a depreciable life of 5 yrs and will have no salvage value. The machine will generate incremental revenues of \$3.8 million per year along with incremental costs of \$1.0 million per year.

If Daily's marginal tax rate is 35%, what are the incremental earnings associated with the new machine?

The annual incremental earnings are \$

2. Cellular Access Inc., is a cellular telephone service provider that reported net operating profit after tax (NOPAT) of \$240 million for the most recent fiscal year. The firm had depreciation expenses of \$120 million, capital expenditures of \$220 million, and no interest expenses. Working capital increased by \$14 million. Calculate the free cash flow for Cellular Access for the most recent fiscal year.

The free cash flow is \$ million

3. Anle Corporation has a current stock price of \$20 adn is expected to pay a dividend of \$1.00 in one year. Its expected stock price right after paying that dividend is \$22.

a. What is Anle's equity cost of capital?
b. How much of Anle's equity cost of capital is expected to be satisfied by dividend yield and how much by capital gain?

4. Summit Systems will pay a dividend of \$1.50 this year. If you expect Summit's dividend to grow by 6.0% per year, what is its price per share if its equity cost of capital is 11.0%?

The price per share is \$

5. Colgate-Palmolive Company has just paid an annual dividend of \$0.96. Analysts are predicting a(n) 11.0% per year growth rate in earnings over the next five years. After that, Colgate's earnings are expected to grow at the current industry average of 5.2% per year. If Colgate's equity cost of capital is 8.5% per year and its dividend payout ratio remains constant, for what price does the dividend-discount model predict Colgate stock should sell?

The price per share \$

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