Problem 1224 Chips Home Brew Whiskey Management Forecasts
Problem 1224chips Home Brew Whiskey Management Forecasts That If The
Determine the effect of a price increase on the firm’s free cash flow (FCF) for the year based on the given data: selling price per bottle, demand at original and increased prices, variable costs, fixed costs, depreciation, taxes, and working capital change.
Additionally, calculate the firm's after-tax weighted average cost of capital (WACC) based on the capital structure, investor-required returns for debt, preferred stock, and common stock, and the firm's tax rate.
Paper For Above instruction
Chip’s Home Brew Whiskey management forecasts that if the firm sells each bottle of Snake-Bite for $20, then the demand for the product will be 15,000 bottles per year. If the price is increased by 16 percent, sales are expected to be approximately 94 percent of the original demand, reflecting price sensitivity. The variable cost per bottle is $10, fixed cash costs are $100,000 annually, depreciation and amortization are $20,000, and the firm’s marginal tax rate is 30 percent. Management also anticipates an increased working capital need of $3,000 for the year. The core task is to analyze the impact of this price increase on the firm’s free cash flow (FCF) for the year. Additionally, the firm’s capital structure comprises 43% debt, 12% preferred stock, and 45% common stock, with respective investor-required returns of 11%, 12%, and 18%. The firm's marginal tax rate is 40%. The goal is to calculate the change in FCF resulting from the price increase and determine the firm's after-tax weighted average cost of capital (WACC).
Calculating the current FCF at the original price ($20 per bottle)
Initially, the firm’s demand at the current price of $20 per bottle is 15,000 units. The total revenue at this price is:
Revenue: 15,000 units × $20 = $300,000
The total variable costs are:
Variable costs: 15,000 units × $10 = $150,000
The contribution margin before fixed costs is:
Contribution margin: $300,000 - $150,000 = $150,000
Subtracting fixed cash costs and depreciation gives earnings before tax:
EBIT: $150,000 - $100,000 - $20,000 = $30,000
Tax on EBIT at 30%:
Taxes: 30,000 × 0.30 = $9,000
Net operating profit after tax (NOPAT):
NOPAT: 30,000 - 9,000 = $21,000
Adding back depreciation (a non-cash expense):
Free cash flow before changes in working capital (FCF):
FCF: NOPAT + Depreciation = $21,000 + $20,000 = $41,000
Adjust for the increase in working capital of $3,000 (cash outflow):
FCF (initial): $41,000 - $3,000 = $38,000
Calculating the new demand and revenue after a 16% price increase
The new price per bottle is:
New price: $20 × (1 + 0.16) = $23.20
Demand at this new price is 94% of original demand:
New demand: 15,000 × 0.94 ≈ 14,100 units
New total revenue:
Revenue: 14,100 × $23.20 ≈ $327,120
New variable costs:
Variable costs: 14,100 × $10 = $141,000
Contribution margin:
Contribution margin: $327,120 - $141,000 = $186,120
EBIT before fixed costs and depreciation:
EBIT: $186,120 - $100,000 - $20,000 = $66,120
Taxes at 30%:
Taxes: 66,120 × 0.30 ≈ $19,836
Net operating profit after tax (NOPAT):
NOPAT: 66,120 - 19,836 ≈ $46,284
Add back depreciation:
FCF before working capital adjustment:
FCF: $46,284 + $20,000 ≈ $66,284
Net change in working capital is an increase of $3,000, so subtract this cash outflow:
FCF (after increase in working capital): $66,284 - $3,000 ≈ $63,284
Summary of the effect of the price increase on FCF
At original price, FCF ≈ $38,000. After the increase, FCF ≈ $63,284. The net increase in FCF due to the price hike is approximately:
Increase in FCF: $63,284 - $38,000 ≈ $25,284
Calculating the firm's after-tax WACC
The capital structure weights are: debt (43%), preferred stock (12%), and common stock (45%).
The cost of debt after tax:
Cost of debt (after-tax): 11% × (1 - 0.40) = 11% × 0.60 = 6.60%
Cost of preferred stock:
Preferred stock: 12%
Cost of common equity:
Common stock: 18%
WACC calculation:
WACC = (Weight of debt × After-tax cost of debt) + (Weight of preferred stock × Cost of preferred stock) + (Weight of equity × Cost of equity)
WACC = (0.43 × 0.066) + (0.12 × 0.12) + (0.45 × 0.18) = 0.02838 + 0.0144 + 0.081 = 0.12378
Expressed as a percentage, the after-tax WACC is approximately:
WACC: 12.38%
This reflects the average cost of capital after taxes, considering the firm's capital structure and the required returns of its financing sources.
Conclusion
The price increase from $20 to approximately $23.20 is projected to increase the firm’s free cash flow for the year by about $25,284, reflecting improved contributions despite slightly reduced demand. Correspondingly, the firm's after-tax WACC is approximately 12.38%, which is vital for valuation and investment decision-making processes. These analyses underscore the importance of aligning pricing strategies with demand elasticity and capital costs to optimize firm valuation and financial performance.
References
- Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management (15th ed.). Cengage Learning.
- Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley Finance.
- Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2018). Fundamentals of Corporate Finance (12th ed.). McGraw-Hill Education.
- Van Horne, J. C., & Wachowicz, J. M. (2008). Fundamentals of Financial Management (13th ed.). Pearson Education.
- Gürkaynak, G., & Kuşçu, A. (2017). Corporate Valuation and Cost of Capital. Journal of Business Economics and Finance.
- Frank, R., & Bernanke, B. (2019). Principles of Economics (7th ed.). McGraw-Hill Education.
- Heaton, J., & Lucas, D. G. (2000). Portfolio Choice and Asset Returns. Journal of Finance.
- Fabozzi, F. J. (2013). Bond Markets, Analysis, and Strategies. Pearson.
- Myers, S. C. (2001). Capital Structure. Journal of Economic Perspectives.
- Damodaran, A. (2020). Applied Corporate Finance (4th ed.). Wiley.