Question 19.2: The projected net income and free cash flows next year for E...
The projected net income and free cash flows next year for Emerald City Paints are given in the following table in $ thousands:
Net Income 20,000
+ Depreciation +5,000
– Capital Expenditures –5,000
– Increase in Working Capital –1,000
= Free Cash Flow 19,000
Emerald City expects capital expenditures and depreciation to continue to offset each other, and for both net income and increase in working capital to grow at 4% per year. Emerald City’s cost of capital is 12%. If Emerald City were able reduce its annual Increase in working capital by 20% by managing its working capital more efficiently without adversely affecting any other part of the business, what would be the effect on Emerald City’s value?
PLAN
A 20% decrease in required working capital increases would reduce the starting point from $1,000,000 per year to $800,000 per year. The working capital increases would still grow at 4% per year, but each increase would then be 20% smaller because of the 20% smaller starting point. We can value Emerald City using the formula for a growing perpetuity from Chapter 4 (Eq. 4.7):
PV(Growing Perpetuity) = \frac{C}{r-g} (4.7)
PV = \frac{\text{Cash Flow}}{r-g}
As shown in the table above, we can determine Emerald City’s free cash flow as:
Net Income + Depreciation – Capital Expenditures – Increases in Working Capital.
EXECUTE
Currently, Emerald City’s value is:
\frac{20,000,000+5,000,000-5,000,000-1,000,000}{.12-.04} = 237,500,000
If they can manage their working capital more efficiently, the value will be:
\frac{20,000,000+5,000,000-5,000,000-800,000}{.12-.04} = 240,000,000
EVALUATE
Although the change will not affect Emerald City’s earnings (net income), it will increase the free cash flow available to shareholders and increase the value of the firm by $2.5 million.