1. Amazon is considering expansion into video games for four years. If it undertakes this...

Question:

1. Amazon is considering expansion into video games for four years.

If it undertakes this expansion project, it would require a capital expenditure of $10 million that the IRS requires to be depreciated over 7 years even though the company plans on selling it in 4 years.

It will be depreciated on a straight-line basis to 0.

It is expected to sell for $5 million in 4 years.

The project also requires $100,000 in cash, $200,000 increase in accounts receivable, an increase of $300,000 inventory, and an increase of $100,000 in accounts payable.

When the project is over, the required net working capital will be recovered.

With sales of $1 million and costs of goods sold of $600,000 every year, and corporate tax rate of 40%, what is the free cash flow of this project in year 4?

a. $5,900,000

b. $5,525,417

c. $6,311,429

d. $6,025,714

e. $5,196,362

2. In January 1, 2017 analysts forecast that Target Inc. will continue to earn $4 per share at the end of the year and every year afterwards. It will pay out all of its earnings as a dividend as it has before.

As of this date, the stock trades at $40.

On January 2, 2017 the company surprised people by hiring a new CEO who will pursue a growth strategy by retaining 50% of future earnings into new projects that will earn the same as the company's ROE of 12%. Next years dividend will be $2.

If the discount rate of Target stock does not change, what should the new stock price be?

a. $50

b.$35

c. $67.77

d. $42.40

e. $100

Free cash flow and Common stock value:

Free cash flow of a company is given as the operating cash flow plus the adjustments for capital expenditure and net working capital. Common stock value is the present value of all the cash flows expected from the stock perpetually.

Answer and Explanation:

Part 1)

Book value of the project after 4 years
= Cost x Remaining life / Useful life
= $10,000,000 x 3 / 7
= $4,285,714.2857

Sales value = $5,000,000.00

Profit on sale = $5,000,000 - $4,285,714.2857 = $714,285.71

Tax on profits = $714,285.71 x 40% = $285,714.28

Sales value net of tax = Sales value - Tax on profits = $4,714,285.72

Now,

Working capital recovered
= Increase in current assets - Increase in current liabilities
= Cash + Accounts receivable + Inventory - Accounts payable
= $100,000.00 + $200,000.00 + $300,000.00 - $100,000.00
= $500,000.00

Also,

So, the free cash flow of the project is:

Particulars Amount
Sales 1,000,000.00
Less: Cost of goods sold 600,000.00
Less: Depreciation 1,428,571.43
Earnings before interest and tax (1,028,571.43)
Less: Tax @ 40% -
Net operating income (1,028,571.43)
Add: Depreciation 1,428,571.43
Operating cash flow 400,000.00
Add: Salvage value net of tax 4,714,285.72
Add: Working capital recovered 500,000.00
Free cash flow 5,614,285.72

Part 2)

The correct choice is Option A.

Current discount rate = Next dividend / Current price = 4 / 40 = 0.10 = 10%

Now,

Growth rate = Retention ratio x ROE = 50% x 12% = 6%

New price
= Next dividend / (Discount rate - Growth rate)
= 2 / (0.10 - 0.06)
= $50.00


Learn more about this topic:

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Operating Cash Flow: Definition & Examples

from Finance 101: Principles of Finance

Chapter 10 / Lesson 4
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