(Determining relevant cash flows) Landcruisers Plus (LP) has operated an online

Question

(Determining relevant cash flows) Landcruisers Plus (LP) has operated an online retail store selling off-road truck parts. As the name implies, the firm specializes in parts for the venerable Toyota FJ40 that is known throughout the world for its durability and offroad prowess. The fact that Toyota stopped building and exporting the FJ40 to the U.S. market in 1982 meant that FJ40 owners depended more and more on re-manufactured parts to keep their beloved off-road vehicles running. More and more FJ40 owners are replacing the original inline six-cylinder engines with a modern American-built engine. The engine replacement requires mating the new engine with the Toyota drive train.

LP's owners had been offering engine adaptor kits for some time but have recently decided to begin building their own units. To make the adaptor kits the firm would need to invest in a variety of machine tools costing a total of $800,000. LP's management estimates that they will be able to borrow $300,000 from the firm's bank and pay 8 percent interest. The remaining funds would have to be supplied by LP's owners.

The firm estimates that they will be able to sell 1,000 units a year for $1,400 each. The units would cost $1,000 each in cash expenses to produce (this does not include depreciation expense of $80,000 per year or interest expense of

$24 000 ). After all expenses, the firm expects earnings before interest and taxes of $320,000. The firm pays taxes equal to 31 percent, which results in net income of $196 comma 800 per year over the 10 -year expected life of the equipment.

a. What is the annual free cash flow LP should expect to receive from the investment in year 1 assuming that it does not require any other investments in either capital equipment or working capital and the equipment is depreciated over a 10 -year life to a zero salvage and book value? How should the financing cost associated with the $300 comma 000 loan be incorporated into the analysis of cash flow?

b. If the firm's required rate of return for its investments is 11 percent and the investment has a 10 -year expected life, what is the anticipated NPV of the investment?

Explanation / Answer

Annual Free cash flow = Net Income + Depreciation 196800+80000 276800 The Interest expense on the loan taken shall be deducted every year to determine the free cash flows of the company Years Cashflows Interest on Loan aftr tax Principal Payment Cashflow inflow from Project Discounting Factor @ 11% Present Value 0 -500000 0 -500000 1 -500000 1 276800 16560 20708.85 239531.15 0.90909091 217755.6 2 276800 15416.87 22365.56 239017.571 0.82644628 197535.2 3 276800 14182.29 24154.8 238462.905 0.7513148 179160.7 4 276800 12848.95 26087.19 237863.866 0.68301346 162464.2 5 276800 11408.93 28174.16 237216.903 0.62092132 147293 6 276800 9853.721 30428.09 236518.184 0.56447393 133508.3 7 276800 8174.09 32862.34 235763.567 0.51315812 120984 8 276800 6360.089 35491.33 234948.581 0.46650738 109605.2 9 276800 4400.968 38330.64 234068.396 0.42409762 99267.85 10 276800 2285.116 41397.09 233117.797 0.38554329 89877 Net Present Value 957451.2 Assuming the Loan has equal installments yearly installments and using the PMT formula in excel we get yearly payment of $44708.85 Years Loan Outstanding at the beginning Interest Payment Principal Payment Total Payment Loan outstanding at the end Aftr Tax Interest @31% 1            3,00,000.00 24000 20708.85 44708.85 2,79,291.15 16560 2            2,79,291.15 22343.29 22365.56 44708.85 2,56,925.59 15416.87 3            2,56,925.59 20554.05 24154.8 44708.85 2,32,770.79 14182.29 4            2,32,770.79 18621.66 26087.19 44708.85 2,06,683.60 12848.95 5            2,06,683.60 16534.69 28174.16 44708.85 1,78,509.44 11408.93 6            1,78,509.44 14280.76 30428.09 44708.85 1,48,081.35 9853.721 7            1,48,081.35 11846.51 32862.34 44708.85 1,15,219.00 8174.09 8            1,15,219.00 9217.52 35491.33 44708.85      79,727.67 6360.089 9                79,727.67 6378.214 38330.64 44708.85      41,397.04 4400.968 10                41,397.04 3311.763 41397.09 44708.85               -0.05 2285.116

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