Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. Canyon Buff is considering a project that requires an initial investment of $9,000 in manufacturing equipment.

The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can be used out into the indefinite future (i.e., the actual useful life is effectively infinite).

Canyon Buff anticipates that the sales will be $30,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity.

The cost of goods sold is estimated to be 72% of sales.

The accounting department also estimates that at introduction in Year 0, the new product's required initial net working capital will be $6,000. In future years accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next year's cost of goods sold and accounts payable are expected to be 15% of the next year's cost of goods sold.

The selling, general and administrative expense is estimated to be $5,000 per year

Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30%.

Questions

1. Use Excel to construct six-year pro forma income statements and calculate the incremental unlevered net income for the first six years.

2. Calculate six-year projections for free cash flows. Remember to include cash flows from the income statement and depreciation, changes in net working capital, and capital expenditures or dispositions.

Hint: You need to calculate the level of net working capital (NWC) and change in NWC. Pay attention to the timing of NWC.

3. Canyon Buff expects that free cash flow from Year 6 onwards will increase at a constant rate of 2%/year into the indefinite future. Calculate PV(terminal value that captures the value of future free cash flows in Year 6 and beyond). That is, calculate the terminal value first, then find its value in Year 0 (today).

Hint:

We went over this in Lecture Note 6, so let me briefly review the key points:

a. Assuming the cash flows grow at a constant rate g after Year N+1, then

Year N TV = (Year N+1 CF)/(rg) (from growing perpetuity formula).

where r is discount rate

b. We should discount this Terminal Value back to Year 0.

4. Determine the NPV of the project. Remember to net out any initial cash outflows.

Can you please check my work? The cells in green are correct values and were given as hints.