What are the free cash flows of the packaging-machine investment? Should Koh approve the investment?
The correct answer and explanation is:
To determine the free cash flows (FCFs) of the packaging-machine investment, you’ll need to break down several components of the investment’s financial impact. Here’s the general method for calculating FCFs:
- Initial Investment: This is the upfront cost of the new packaging machine. It’s typically a large capital expenditure, which would be recorded as a cash outflow in the first year.
- Revenue Impact: The packaging machine should increase the production capacity or efficiency, which may result in increased revenue. You would estimate how much more revenue the company expects to generate annually due to the investment.
- Operating Costs: The new machine might also affect operating costs, either by reducing labor or increasing maintenance costs. Calculate the net effect on operating costs annually.
- Depreciation: The machine will be depreciated over its useful life, which will reduce taxable income. You calculate depreciation based on the machine’s cost and its expected lifespan.
- Tax Effects: The depreciation lowers taxable income, which results in tax savings. You would multiply the depreciation amount by the company’s tax rate to calculate the tax savings.
- Changes in Working Capital: If the investment leads to an increase in inventory, accounts receivable, or other working capital accounts, this would represent an additional cash outflow in the initial years.
- Terminal Value: At the end of the machine’s useful life, the company may sell it, resulting in a cash inflow. This is the terminal value of the machine.
Once you have these components, you can calculate the free cash flow for each year by subtracting capital expenditures, changes in working capital, and taxes from the operating cash inflows.
Should Koh approve the investment?
Koh should approve the investment if the net present value (NPV) of the free cash flows is positive. This means that the future cash inflows (adjusted for the time value of money) are greater than the initial investment. If the NPV is negative, it would indicate the investment may not be financially beneficial in the long run. The internal rate of return (IRR) should also be compared to the company’s required rate of return, and if the IRR exceeds this rate, it further supports approval.