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Free Cash Flow & Project Valuation

Case Study: Free Cash Flow & Project Valuation

Company "A" is considering the launch of a new product. The company currently uses 35% tax bracket with 15% discount rate. Expected duration of the project is five years, then terminated. See information as follows:

Cost of new plant & equip: $7,900,000
Shipping and Installations Costs: $100,000
Unit sales: Year 1 - 70,000, Year 2 - 120,000, Year 3 - 140,000, Year 4 - 80,000, Year 5 - 60,000.
Sales price per unit: $300/unit in years 1-4 and $260/unit in year 5.
V/C per unit: $180/unit
Annual fixed costs: $200,000 per year
Initial capital cost - $100,000; each year the total investment in net working capital is 10% of the dollar value of sales for that year. The investment in working capital will increase in years 1-3, decrease in year 4 and liquidated at the end of the project, year 5.

1.Why should company "A" focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?

Solution Preview

1.Why should company "A" focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?

When we look at accounting profit, we're taking into consideration the total amount of revenue less operating expenses to derive net income. This takes into consideration all of the incoming and outgoing cash to and from the business in the given accounting period. This provides us with valuable information, that management can then use for budgeting and project ...

Solution Summary

This solution explains why a company would want to focus on a project's free cash flow instead of focusing on the accounting profits generated by the project based on the information provided.

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