Gizmo Inc has outstanding 5 year bonds with a 12% coupon rate, annual payments s
ID: 2799274 • Letter: G
Question
Gizmo Inc has outstanding 5 year bonds with a 12% coupon rate, annual payments selling for $1,300. Its preferred stock is selling for $150 and pays a fixed dividend of $12. Gizmo Inc. common stock is selling for $200 and has a beta of 1. The risk-free rate is 5% and the expected return on the market is 12%. The target Capital structure calls for 40% debt, 20% Preferred Stock, and 40% Common Equity.
Gizmo Inc. is considering the purchase of a new machine for 200,000. It will be depreciated using the MACRS 3-year class life [33%, 45%, 15% and 7%] and can be used for three years at which time it will have a market value of $30,000. Purchase of the new machine will cause an increase in net operating working capital by $10,000. Sales are expected to increase by $100,000 per year. The new machine will be depreciated using the MACRS 3-year class life.
1. What is the after-tax cash flow from the sale of the machine at the end of the third year?
2. What is the Free Cash Flow for year 0?
3.What is the Free Cash Flow for year 1?
4. What is the Free Cash Flow for year 2?
5. What is the Free Cash Flow for year 3?
Explanation / Answer
1) Tax rates are not given, the cash flow from sale of machine at the end of the 3rd year shall be $30,000.
2) Free Cashflows at Year 0 =
New Machinery Cost = $200,000
Increase in net working capital = $10,000
Total free cash flows at year 0 = Minus $210,000
3) Free cash flow at Year 1 = $100,000
4) Free cash flow at Year 2 = $100,000
5) Free cash flow at Year 3
Net income from operations = $100,000
Add: Sale of machinery = $ 30,000
Net working capital = $ 10,000
Total = $140,000
In the above question, there is no mention about the tax rate and no where it is asked to get the present value of future cash flows and hence no discounting factor is considered.
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