You are evaluating a project for The Ultimate recreational tennis racket, guaranteed to correct that wimpy backhand. You estimate the sales price of The Ultimate to be $300 per unit and sales volume to be 1,000 units in year 1; 1,250 units in year 2; and 1,325 units in year 3. The project has a three-year life. Variable costs amount to $200 per unit and fixed costs are $50,000 per year. The project requires an initial investment of $150,000 in assets which will be depreciated straight-line to zero over the three-year project life. The actual market value of these assets at the end of year 3 is expected to be $25,000. NWC requirements at the beginning of each year will be approximately 10 percent of the projected sales during the coming year. The tax rate is 21 percent and the required return on the project is 10 percent. What will the free cash flow for this project be in year 3?
A) $142,000
B) $167,000
C) $135,175
D) $122,250

Question

Quizplus · Accepted Answer

To calculate the free cash flow for the project in year 3, we need to consider several components: operating cash flow, changes in net working capital (NWC), and capital spending. 1. **Operating Cash Flow (OCF)**: This can be calculated using the formula: OCF = (Sales - Variable Costs - Fixed Costs - Depreciation) * (1 - Tax Rate) + Depreciation. For year 3, Sales = 1,325 units * $300/unit = $397,500; Variable Costs = 1,325 units * $200/unit = $265,000; Fixed Costs = $50,000; Depreciation = $150,000 / 3 years = $50,000. Thus, OCF = ($397,500 - $265,000 - $50,000 - $50,000) * (1 - 0.21) + $50,000 = $32,500 * 0.79 + $50,000 = $25,675 + $50,000 = $75,675.2. **Change in NWC**: The change in NWC is the difference in NWC from year 2 to year 3. NWC for year 3 is 10% of sales for year 4 (since there's no year 4, we assume sales would not increase), so NWC for year 3 = 10% of $397,500 = $39,750. NWC for year 2 = 10% of year 3 sales (1,250 units * $300/unit) = $37,500. The change in NWC from year 2 to year 3 = $39,750 - $37,500 = $2,250. Since it's the last year, we recover the NWC, so it's -$2,250 (a cash inflow).3. **Capital Spending**: At the end of year 3, the assets are sold for $25,000. This is a cash inflow and considered a part of the capital spending component. Since the assets were depreciated to zero, the entire sale price is a gain.Therefore, the free cash flow for year 3 = OCF + Change in NWC + Sale of Assets = $75,675 - $2,250 + $25,000 = $98,425.However, none of the provided options match the calculated value. Given the options and the methodology, it seems there might have been a mistake in the calculation or interpretation of the question's requirements. The correct approach involves calculating the operating cash flow correctly, accounting for changes in net working capital, and including the salvage value of the assets. The provided answer choices and the calculation do not align, suggesting a possible misunderstanding in the calculation steps or the question's details. Re-evaluating the calculation steps or clarifying the question's details might be necessary to arrive at the correct answer.

You Are Evaluating a Project for the Ultimate Recreational Tennis