Advanced Corporate Finance
Practice Problem Set 3

3

2. Cash Flows for High-Volume Espresso Machines

The executives of a coffee and beverage chain are considering investing in a new line of high-volume
espresso machines. The machines are expected to allow faster processing of customer orders and
increase sales volume. They also require slightly higher grade coffee beans and more experienced
operators of the machines, so that investing in the technology would also raise the cost of goods sold
as well as selling and administrative expenses.

As a management consultant advising the chain, you are initially given the following information:

x The machines would be purchased in late 2016 at a cost of $200 million and are expected to
have a salvage value of $50 million at the end of 2021, when they would be sold.

x Net working capital will have to increase by $5 million during 2016 to prepare for the
installation and operation of the machines.

x For years 2017-2021, net working capital devoted to this project will have to equal 20% of
incremental sales from these machines.

x The corporate tax rate is 35% and depreciation is the same for accounting purposes and tax
purposes.

x Some income statement items as follows:

Year
2017 2018 2019 2020 2021

Income Statement Items for Existing Business

Sales 360 492 840 942 720
Cost of Goods Sold 156 210 360 408 312
Selling and Administrative Expenses 60 78 132 150 114
Depreciation 18 18 18 18 18
Interest 30 24 24 18 18

Advanced Corporate Finance
Practice Problem Set 3

4

Forecast of Incremental Income Statement Items for New Machines

Sales 76 98 164 132 99
Cost of Goods Sold 19 15 21 26 22
Selling and Administrative Expenses 12 14 15 14 12
Depreciation 4 4 4 4 4
Interest 6 5 5 4 4

a.) Calculate EBIDTA, EBIT, EBIAT, and accounting net income for the existing business for 2017-
2021. Then calculate the amounts by which these values would change if the new technology were
adopted.

b.) A highly caffeinated divisional executive of the chain calls you and suggests that he has already
worked out the NPV of the project. He says that he discounted 2017-2021 accounting net income that
would result from the project and that this value was highly positive. Therefore he sees no reason to
hesitate in proceeding with the project. Explain what is wrong with this reasoning. (Do not bother to
replicate his calculations.)

c.) An even more caffeinated divisional executive of the chain calls you a few minutes later and says
that she also found that the NPV of the project is highly positive. She says that she discounted 2016-
2021 free cash flows from the firm as a whole including the flows from the new project and that this
value was highly positive. Therefore she insists that they should immediately proceed with the
project. Explain what is wrong with this reasoning. (Do not bother to replicate her calculations.)

d.) Calculate the incremental free cash flow for each of the years 2016-2021 that would result from
adopting the project.

e.) After seeing your projections of incremental cash flows for the years 2016-2021, the CEO of the
chain calls you and says that he is worried that the divisional executives have been ignoring some cash
flows that are related to this project. In particular, he knows that they hired marketing researchers and
paid them $10 million in January 2016 for a study on the elasticity of consumer demand with respect
to espresso drink waiting times. Therefore he argues that an additional $10 million charge should be
subtracted in 2016, at very least to make sure the divisional executives realize the costs they are
imposing on the company. Evaluate this argument.

f.) Is there a discount rate at which the NPV of this project’s cash flows would be exactly (or almost
exactly) zero?