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, whereas sales will be 85 percent as high if the price is raised 16 percent. Chip’s variable cost per bottle is $10, and the total fixed cash cost for the year is $100,000. Depreciation and amortization charges are $20,000, and the firm has a 30 percent marginal tax rate. Management anticipates an increased working capital need of $3,000 for the year. What will be the effect of the price increase on the firm’s FCF for the year
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, whereas sales will be 90 percent as high if the price is raised 10 percent. Chip’s variable cost per bottle is $10, and the total fixed cash cost for the year is $100,000. Depreciation and amortization charges are $20,000, and the firm has a 30 percent marginal tax rate. Management anticipates an increased working capital need of $3,000 for the year. What will be the effect of the price increase on the firm’s FCF for the year?
20
To determine the effect of the price increase on the firm's Free Cash Flow (FCF) for the year, we need to calculate the changes in revenue, variable costs, fixed costs, and working capital.
First, let's calculate the revenue before and after the price increase:
- Selling price per bottle: $20
- Original demand: 15,000 bottles per year
- Original revenue: $20 x 15,000 = $300,000
The sales will be 85% as high after the price increase of 16%:
- New selling price per bottle: $20 + ($20 x 16%) = $20 + $3.20 = $23.20
- New demand: 85% of the original demand = 0.85 x 15,000 = 12,750 bottles per year
- New revenue: $23.20 x 12,750 = $296,400
Next, let's calculate the variable costs:
- Variable cost per bottle: $10
- Original variable costs: $10 x 15,000 = $150,000
- New variable costs: $10 x 12,750 = $127,500
Now, let's calculate the fixed costs:
- Total fixed cash cost: $100,000
- Depreciation and amortization charges: $20,000
- Total fixed costs: $100,000 + $20,000 = $120,000
Moving on to working capital:
- Increased working capital need: $3,000
Finally, let's calculate the FCF for the year:
Original FCF = Revenue - Variable Costs - Fixed Costs - Depreciation and Amortization - Taxes - Working Capital
New FCF = New Revenue - New Variable Costs - Fixed Costs - Depreciation and Amortization - Taxes - Working Capital
To calculate taxes and related variables, we need to determine the tax expense:
- Marginal tax rate: 30%
Tax Expense = (Revenue - Variable Costs - Fixed Costs - Depreciation and Amortization) x Marginal Tax Rate
Original Tax Expense = ($300,000 - $150,000 - $120,000 - $20,000) x 30% = $10,500
New Tax Expense = ($296,400 - $127,500 - $120,000 - $20,000) x 30% = $8,490
Now, we can calculate the FCF for the year:
Original FCF = $300,000 - $150,000 - $120,000 - $20,000 - $10,500 - $3,000 = $-3,500 (negative FCF)
New FCF = $296,400 - $127,500 - $120,000 - $20,000 - $8,490 - $3,000 = $17,410
Therefore, the price increase will increase the firm's FCF for the year to $17,410.