Your company is looking at introducing a new product into its product line. Yourcompany expects that this new product would be offered into perpetuity. It is expected todecrease the firm's FCF8 immediately by $36 million and $22 million next year. Startingin year 2, the firm's FCF8 will increase by $10 million. These incremental FCF8 willthen decrease at a rate of 2% into perpetuity (i.e. year 3's incremental FCF will be10M*(1+(-0.02)) = 9.8M, and so on). If the firm's discount rate is 12%, is this a goodinvestment?2.

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Asked Oct 26, 2019
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I am struggling with this problem as well and how to approach setting it up in excel. I'm using the Pearson Corporate Finance book 4th edition stand alone by Berk.

Your company is looking at introducing a new product into its product line. Your
company expects that this new product would be offered into perpetuity. It is expected to
decrease the firm's FCF8 immediately by $36 million and $22 million next year. Starting
in year 2, the firm's FCF8 will increase by $10 million. These incremental FCF8 will
then decrease at a rate of 2% into perpetuity (i.e. year 3's incremental FCF will be
10M*(1+(-0.02)) = 9.8M, and so on). If the firm's discount rate is 12%, is this a good
investment?
2.
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Your company is looking at introducing a new product into its product line. Your company expects that this new product would be offered into perpetuity. It is expected to decrease the firm's FCF8 immediately by $36 million and $22 million next year. Starting in year 2, the firm's FCF8 will increase by $10 million. These incremental FCF8 will then decrease at a rate of 2% into perpetuity (i.e. year 3's incremental FCF will be 10M*(1+(-0.02)) = 9.8M, and so on). If the firm's discount rate is 12%, is this a good investment? 2.

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Expert Answer

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Step 1

Initial Investment of New Product = Decrease in Firm’s FCFs of Current Year = $36 Million

Cash Flow of Year 1 = Decrease in Firm’s FCFs of Year 1 = $22 Million

Cash Flow of Year 2 = $80 Million

Discounting Rate = 12%  

 

Calculation of Present Value of FCFs using excel:

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А В C Present Value of Cash Flow Discounting (in Million) Rate (12% Year Cash Flow (in Million) 1 -B2*C2 |-В3*СЗ |=1/(1.12)^2|=B4*C4 |=SUM(D2:D4) 2 0 3 1 -36 -22 80 5 Net Present Value |=1/(1.12) 4 2

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Step 2

The result of above table is as follows:

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Step 3

Working Notes:

 

  1. Terminal Value

Incremental FCFs of Year 3 and so on = $10 Million × (1 + (-0.02)) = 9.8 M

Perpetual Growth Rate of FCFs = -2%

Discounting Rate or Weight...

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Incremental FCFS Terminal Value of Perpetual FCFS - WACC Perpetual Growth Rate of FCFs $9.8Million 12%-(-2%) $9.8 Million 14% =$70 Million

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