Free cash flow
You have been asked by the president of Jurong Parts to evaluate the proposed acquisition of a Computer Numeric Control (CNC) machine to manufacture a new type of alternator, ALT375. A feasibility study was commissioned three months ago at a cost of $65,000 to evaluate this opportunity.
The equipment’s basic price is $700,000, and it would cost another $50,000 to modify it for special use by your firm.
Based on findings from the feasibility study, Jurong Parts expects to sell 2,000 alternators in the first year. Demand is expected to increase by 400 units each year for the next three years. Thereafter, demand will fall by half. No sales are expected from year six onwards because cars using this part will all be scrapped.
Selling price is $250 per unit and not expected to fluctuate over the project life. The firm anticipates to earn a gross profit margin of 35%. Fixed operating costs in the first year is estimated to be $50,000 in year one and this will increase by inflation rate of 3%. Based on past experience, net working capital required, namely spare parts inventory, will be 10% of sales.
The CNC machine would depreciated equally over 3 years to zero net book value. However, it can be sold for $35,000 at the end of the project life. The firm’s marginal tax rate is 17% and the appropriate discount rate is 12%.
- (a) Calculate the free cash flow from Year 0 to 5 relating to the proposed manufacturing of ALT375. (28 marks)
- (b) Calculate the net present value (NPV) of this opportunity and determine whether Jurong Parts should proceed with this project.
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(4 marks)
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