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    Free Cash Flow, Net Present Value, Internal Rate of Return

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    Problem 1

    TCM Petroleum is an integrated oil company headquartered in Fort Worth, Texas. The following are the information on its income statements for 2007 and 2008 (all dollar figures are in millions):


    Sales: $12,200.00, cost of goods sold: 72% of sales, depreciation: $850.00, additional CAPEX: $900.00, additional investment in net working capital: $150.00


    Sales: $14,500.00, cost of goods sold: 78% of sales, depreciation: $970.00, additional CAPEX: $1,200.00, additional investment in net working capital: $200.00

    Applicable tax rate for the company is 38%.

    a. Calculate TCM's free cash flows (FCF) for 2007 and 2008
    b. Estimate TCM's FCF for 2009-2013 using the following assumptions: Company's sales will grow at 15% per year over the next five years, cost of goods sold is expected to increase by 2% each year from its 2008 level, CAPEX is expected to be additional 10% of additional sales per year, additional net working capital per year will be equal to 5% of additional sales, depreciation expenses will equal to the prior year total plus 10% additional CAPEX of each year. Since TCM is a going concern, we need not be concerned about the liquidation value of the firm's assets at the end of 2013.

    Problem 2

    Phantom Pharmaceutical manufactures and sells generic over-the-counter drugs in plants located throughout the country. One of its plants is trying to decide whether to automate a portion of its packaging process by purchasing an automated waste disposal and recycling machine.

    The proposed machine costs $400,000 and it will have a five year anticipated life and will be depreciated by using 3-year MACRS depreciation method toward a zero salvage value. (MACRS depreciation rates are: Year 1: 33%, Year 2: 45%, Year 3: 15% and Year 4: 7%) However, the plant will be able to sell the machine in the after-market for 25% of its original costs at the end of year 5. The firm estimates that the installation of the waste-handling system will bring annual costs savings of $25,000 from reduced labor costs, $10,000 per year from reduced waste disposal costs, and $125,000 per year from the sales of reclaimed plastic waste net of selling expenses. Phantom requires a 16% of return from its investment and faces a 35% tax rate.

    a. Calculate the NPV and IRR for the project. Should Phantom invest in this machine?
    b. The manager of the plant raised some concerns about the revenues from the sale of reclaimed plastic waste. He projects that the price of the reclaimed plastic in year 1 could be 10% to 30% less than what was projected. However, the savings from reduced labor costs and reduced waste disposal costs would remain same. He presented the following probability distribution on the projected reclaimed plastic sales:
    Remain same as projected 40%
    Decrease by 10% 30%
    Decrease by 30% 20%
    Decrease by 50% 10%
    Estimate the NPV and IRR for each of these scenarios. Estimate the expected NPV. Should the company invest in the machine under this revised analysis?

    c. At what sales volume of reclaimed plastic, Phantom would have a break-even NPV=0?

    Problem 3

    Amgel Manufacturing Company's current capital structure is comprised of 40% debt and 60% equity (based on market values). Amgel's equity beta (based on its current level o debt financing) is 1.4 and its debt beta is 0.32. Also, the risk free rate of interest is currently 3.5% on long-term government bonds. Amgel's cost of debt is 8%. Amgel's investment banker advised the firm that, according to its estimates, the market risk premium is 6.5%.

    1. What is your estimate of the cost of equity capital for Amgel (based on the CAPM)?

    2. If Amgel's marginal tax rate is 35%, what is the firm's overall weighted average cost of capital?

    3. Amgel is considering a major expansion of its current business operations. The firm's investment banker estimates that Amgel will be able to borrow to 40% of the needed funds and maintain its current credit rating and borrowing cost. Estimate the WACC for the project.

    Problem 4

    "Multiples valuation" Problem

    Free Travel, Inc., a company that organizes virtual travel tours, is planning an IPO. Its current investors hold 300,000 shares, which at IPO will be converted into common shares at 1:1 ratio. The company competes with the following publicly traded companies: CoachTraveler, VirtualExplorer, Home World, and Stay-at-Home.

    Using the Method of multiples based on both P/E ratio and the enterprise value to EBITDA ratio, at what price should the stock be offered? Use the data from the Table below:

    Financial Information CoachTraveler VirtualExplorer Home World Stay-at-Home Free Travel
    Shares Outstanding 150,000 600,000 500,000 1,000,000 300,000
    Current Stock Price $12.00 $24.00 $34.00 $35.00
    Market Capitalization $ 1,800,000 $ 14,400,000 $ 17,000,000 $ 35,000,000
    Short Term Debt $ 15,000 $ - $ 200,000 $ - $ -
    Long Term Debt $ - $ 2,750,000 $ 1,245,000 $ - $ 1,000,000
    Cash & Equivalents $ 400,000 $ 700,000 $ 1,500,000 $ 4,000,000 $ 600,000
    Short Term Investments $ 90,000 $ 600,000 $ 250,000 $ 5,000,000
    EBITDA $ 218,100 $ 395,300 $ 450,000 $ 1,540,000 $ 400,000
    Net Income $ (40,500) $ 237,900 $ 291,800 $ 894,500 $ 265,000

    Which of the four comparable firms is/are the best comparison firm(s) for Free Travel? Why?

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    Solution Summary

    This solution provides calculations regarding free cash flows, net present value, internal rate of return, cost of equity, and WACC.