Reference no: EM13684126

Dell is now a private company. So I have changed the firm to Hewlett-Packard Company (HPQ).

As an intern in the capital budgeting division of Hewlett-Packard Company (HPQ), your first assignment is to determine the free cash flows and a battery of capital budgeting criteria of a proposed new type of tablet computer system similar in size to an iPad, but with the operating power of a high-end desktop system.

Investments (CAPEX): Development of the new system will initially require an initial investment (CAPEX) equal to 10% of net Property, Plant, and Equipment (PPE) at the end of fiscal year 2014 (October 31 in this case). The project will then require an additional investment at year 1 equal to 10% of previous year's net PP&E. Then in year 2 net PP&E increases by 5%, and increases by 1% in the third, fourth, and fifth years.

Revenues (sales): First-year revenues for the new product are expected to be 3% of total revenue for HPQ's fiscal year ended October 31, 2014. 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.

NWC and depreciation: 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.

The product is expected to have a life of five years. Your job is to determine the rest of the cash flows associated with this project. Welcome to the "real world." Since your boss hasn't been much help, here are some tips to guide your analysis:

1. Download HPQ's financial statements from Mergent Online.

2. You are now ready to estimate the Free Cash Flow for the new product. Compute the Free Cash Flow for each year using the following equation:

FCF = EBIT * (1 - Tax Rate) + Depreciation - CapEx - Change in NWC

where EBIT = Revenues - Costs - Depreciation & Amortization (in the case of this new project, there is no amortization.)

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.

a) Assume that the project's profitability will be about 1% higher relative to HPQ's existing projects in 2014 (fiscal year ended October 31, 2014). Estimate gross profits (revenues -costs) each year by using the adjusted (1% higher) 2014 (EBITDA/Sales) margin, so that your gross profits for each year are the 2014 EBITDA/sales -ratio multiplied by your sales in the subsequent years.

b) Determine the annual depreciation by assuming HPQ depreciates these assets by the straight-line method over a 10-year life. Depreciation is calculated based on the net PP&E for each year.

c) Assume that you sell the net PP&E at year 6 for its book value.

d) Determine HPQ's tax rate by using the income tax rate in 2014.

e) 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 HPQ's 2014 NWC/Sales 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, HPQ's cash holdings.) Assume that NWC is required for years 1 to 5. At year 6 you should close your NWC account.

f) To determine the free cash flow, calculate the additional capital investment and the change in net working capital each year. Assume that (1) Equipment is sold at book value at year 6 when the operations cease, and (2) the NWC account is recovered when operations cease. Note: don't be surprised of your NWC and the change in NWC are negative.

3. Determine the NPV, IRR, and Payback period of the project at a cost of capital of 10% using the Excel spreadsheets. Include free cash flows 0 through 6 in the NPV calculation.

4. Perform a sensitivity analysis by varying the project forecasts as follows:         

a. suppose first year sales will equal 2%-4% of HPQ's revenues.

b. Suppose cost of capital is 8%-15%

c. Suppose revenue growth is constant after the first year at a rate of 0%-10%.