A firm considers to buy a machine in 2020. The cost of that machine is $ 5 000 000. The firm uses 5 year straight line depreciation which allows it to write off $ 1 000 000 depreciation expense each year. The firm is subject to 20% corporate tax rate. The firm's revenue in 2021 is expected to be $ 6 000 000 if the investment is not done. The revenue will be $ 9 000 000 if the investment is done. The firm's total costs (including both COGS and General&Administrative Costs) will be $ 4 000 000 if the investment is not done. The total costs will be $ 5 500 000 if the investment is done. Also the following information is given for the year 2021

Without Investment With Investment

Inventories $ 300 000 $ 500 000

Acc. Receivables $ 200 000 $ 300 000

Acc. Payables $ 100 000 $ 150 000

Given the above information, calculate the free cash flow of that investment for the years 2020 and 2021.

Answer and Explanation:

The computation of the free cash flow of the investment for the year 2020 and 2021 is shown below:

Particulars Case 1 Case 2

Without Investment With Investment

Add: Earnings Before

Interest and

Tax * (1 - Tax Rate) $2,000,000 $2,500,000

Add: Non Cash Expenses $0 $1,000,000

less: Change in

(Current Assets

- Current Liabilities) ($400,000) ($650,000)

Less: Capital Expenditure $0 ($5,000,000)

Free Cash Flows $1,600,000 ($2,150,000)

Working notes:

1.

Particulars Without Investment With Investment

Revenue for the Year 2021 $6,000,000 $9,000,000

Less: Cost of Goods Sold $4,000,000 $5,500,000

(-) Depreciation $0 $1,000,000

Earnings Before

Interest and Tax $2,000,000 $2,500,000

Tax Savings on Depreciation

(Depreciation * 20%) $0 $200,000

2.

Current Assets Without Investment With Investment

Inventories $300,000 $500,000

Accounts Receivable $200,000 $300,000

Total $500,000 $800,000

(Less: Current Liabilities)

Accounts Payable $100,000 $150,000

Less: Change in

(Current Assets

- Current Liabilities) $400,000 $650,000