You have just been hired by Internal Business Machines Corporation (IBM) in their capital budgeting division. Your first

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You have just been hired by Internal Business Machines
Corporation (IBM) in their capital budgeting division. Your first
assignment is to determine the free cash flows and NPV of a
proposed new type of tablet computer similar in size to an iPad but
with the operating power of a high-end desktop system.
Development of the new system will initially require an initial
capital expenditure equal to 10% of IBM’s Property, Plant, and
Equipment (PPE) at the end of the latest fiscal year for which data
is available. The project will then require an additional
investment equal to 10% of the initial investment after the first
year of the project, a 5% increase after the second year, and a 1%
increase after the third, fourth, and fifth years. The product is
expected to have a life of five years. Firstyear revenues for the
new product are expected to be 3% of IBM’s total revenue for the
latest fiscal year for which data is available. The new product’s
revenues are expected to grow at 15% for the second year then 10%
for the third and 5% annually for the final two years of the
expected life of the project. Your job is to determine the rest of
the cash flows associated with this project. Your boss has
indicated that the operating costs and net working capital
requirements are similar to the rest of the company and that
depreciation is straight-line for capital budgeting purposes. Since
your boss hasn’t been much help (welcome to the “real world”!),
here are some tips to guide your analysis :
Obtain IBM's financial statements. (If you really worked
for IBM you would already have this data, but at least you won't
get fired if your analysis is off target.) Download the annual
income statements, balance sheets, and cash flow statements for the
last four fiscal years from Yahoo! Finance (finance.yahoo.com).
Enter IBM's ticker symbol and then go to “financials.”
B. You are now ready to determine the Free Cash Flow. Compute
the Free Cash Flow for each year.
Free Cash Flow = (Revenues - Costs - Depreciation) x (1 - τ c) +
Depreciation - CapEx - Δ NWC
Set up the timeline and computation of free cash flow in
separate, contiguous columns for each year of the project life. Be
sure to make outflows negative and inflows positive .
1. Assume that the project’s profitability will be similar to
IBM’s existing projects in the latest fiscal year and estimate
(revenues - costs) each year by using the latest EBITDA/Sales
profit margin. Calculate EBITDA as EBIT + Depreciation expense from
the cash flow statement.
2. Determine the annual depreciation by assuming IBM depreciates
these assets by the straightline method over a five-year life.
3. Determine IBM’s tax rate by using the current U.S. federal
corporate income tax rate.
4. Calculate the net working capital required each year by
assuming that the level of NWC will be a constant percentage of the
project’s sales. Use IBM’s NWC/Sales for the latest fiscal year to
estimate the required percentage. (Use only accounts receivable,
accounts payable, and inventory to measure working capital. Other
components of current assets and liabilities are harder to
interpret and not necessarily reflective of the project’s required
NWC—for example, IBM’s cash holdings.)
5. To determine the free cash flow, deduct the additional
capital investment and the change in net working capital each
year.
6. Use Excel to determine the NPV of the project with a 12% cost
of capital. Also calculate the IRR of the project using Excel's IRR
function.
7. Perform a sensitivity analysis by varying the project
forecasts as follows:
Suppose first year sales will equal 2%-4% of IBM's revenues.
Suppose the cost of capital is 10%-15%.
Suppose revenue growth is constant after the first year at a
rate of 0%–10%.
Capital Budgeting