Problem 12.24
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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 94 percent as high if the price is raised 8 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? (Round answers to nearest whole dollar, e.g. 5,275.)
To find the effect of the price increase on the firm's Free Cash Flow (FCF) for the year, we need to calculate the FCF before and after the price increase.
First, let's calculate the FCF before the price increase:
1. Calculate the revenue before the price increase:
Revenue = Price per bottle x Demand
Revenue = $20 x 15,000 bottles
Revenue = $300,000
2. Calculate the cost of goods sold (COGS):
COGS = Variable cost per bottle x Demand
COGS = $10 x 15,000 bottles
COGS = $150,000
3. Calculate the operating cash flow before taxes:
Operating CF (Before Taxes) = Revenue - COGS - Total Fixed Cash Cost
Operating CF (Before Taxes) = $300,000 - $150,000 - $100,000
Operating CF (Before Taxes) = $50,000
4. Calculate taxes:
Taxes = Marginal Tax Rate x (Operating CF (Before Taxes) - Depreciation - Amortization)
Taxes = 0.30 x ($50,000 - $20,000)
Taxes = $9,000
5. Calculate FCF before the price increase:
FCF (Before) = Operating CF (Before Taxes) - Taxes - Increase in Working Capital
FCF (Before) = $50,000 - $9,000 - $3,000
FCF (Before) = $38,000
Next, let's calculate the FCF after the price increase:
1. Calculate the new demand after the price increase:
New Demand = Demand x Sales after the price increase
New Demand = 15,000 bottles x 0.94
New Demand = 14,100 bottles
2. Calculate the revenue after the price increase:
Revenue (After) = New Price per bottle x New Demand
Revenue (After) = ($20 + 8% of $20) x 14,100 bottles
Revenue (After) = $21.60 x 14,100 bottles
Revenue (After) = $304,560
3. Calculate the new COGS:
COGS (After) = Variable cost per bottle x New Demand
COGS (After) = $10 x 14,100 bottles
COGS (After) = $141,000
4. Calculate the operating cash flow after taxes:
Operating CF (After Taxes) = Revenue (After) - COGS (After) - Total Fixed Cash Cost
Operating CF (After Taxes) = $304,560 - $141,000 - $100,000
Operating CF (After Taxes) = $63,560
5. Calculate taxes after the price increase:
Taxes (After) = Marginal Tax Rate x (Operating CF (After Taxes) - Depreciation - Amortization)
Taxes (After) = 0.30 x ($63,560 - $20,000)
Taxes (After) = $12,768
6. Calculate FCF after the price increase:
FCF (After) = Operating CF (After Taxes) - Taxes (After) - Increase in Working Capital
FCF (After) = $63,560 - $12,768 - $3,000
FCF (After) = $47,792
Finally, let's find the effect of the price increase on the firm's FCF for the year:
Effect on FCF = FCF (After) - FCF (Before)
Effect on FCF = $47,792 - $38,000
Effect on FCF = $9,792
Therefore, the effect of the price increase on the firm's FCF for the year is $9,792.