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Elmdale Enterprises is deciding whether to expand its production facilities. Although​ long-term cash flows are difficult to​ estimate, management has projected the following cash flows for the first two years​ (in millions of​ dollars): Year 1 Year 2 Revenues 129.5 151.4 COGS and Operating Expenses​ (other than​ depreciation) 32.9 65.7 Depreciation 20.4 36.7 Increase in Net Working Capital 2.7 7.4 Capital Expenditures 33.1 40.1 Marginal Corporate Tax Rate 35​% 35​% a. What are the incremental earnings for this project for years 1 and​ 2?​ (Note: Assume any incremental cost of goods sold is included as part of operating​ expenses.) b. What are the free cash flows for this project for years 1 and​ 2?

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Answer:

a)

incremental earnings year 1 = $49.53 million

incremental earnings year 2 = $31.85 million

b)

free cash flow year 1 = $34.13 million

free cash flow year 2 = $21.05 million  

Explanation:

                                                                         Year 1          Year 2

Revenues                                                          129.5            151.4

COGS & Oper. Exp.​ (not​ depreciation)            32.9             65.7

Depreciation                                                      20.4             36.7

Increase in Net Working Capital                        2.7               7.4

Capital Expenditures                                         33.1             40.1

Marginal Corporate Tax Rate                           35​%             35​%

incremental earnings year 1 = (revenues - COGS - depreciation) x (1 - tax rate) = (129.5 - 32.9 - 20.4) x (1 - 35%) = $49.53 million

incremental earnings year 2 = (revenues - COGS - depreciation) x (1 - tax rate) = (151.4 - 65.7 - 36.7) x (1 - 35%) = $31.85 million

free cash flow year 1 = incremental earnings + depreciation - increase in net working capital - capital expenditures = [(129.5 - 32.9 - 20.4) x (1 - 35%)] + 20.4 - 2.7 - 33.1 = $34.13 million

free cash flow year 2 = incremental earnings + depreciation - increase in net working capital - capital expenditures = [(151.4 - 65.7 - 36.7) x (1 - 35%)] + 36.7 - 7.4 - 40.1 = $21.05 million  

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