Question

Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this facility to various agencies and groups providing relief services to the area. THSI estimates that this project will initially cost $5 million to setup and will generate $20 million in revenues during its first and only year in operation (paid in one year). Operating expenses are expected to total $12 million during this year and depreciation expense will be another $3 million. THSI will require no working capital for this investment. THSI's marginal tax rate is 35%.Required:1. Ignoring the original investment of $5 million, what is THSI's free cash flow for the first and only year of operation?a. $5.0 millionb. $3.75 millionc. $8.0 milliond. $6.25 million

Answer 1

Option D. $6.25 Million

Step-by-step explanation:

The Free Cash Flow can be calculated using the following formula (Ignoring investment):

Free Cash Flow = (Revenue - Operating Expenses) Minus Tax

Here

Revenue is $20 Million

Operating Expenses are $12 Million

And

Tax is not given however tax rate is given which is 35% here. For tax purposes, we will assume that the depreciation is tax allowable expense, so

Tax = (Revenue - Operating Expenses - Depreciation) * Tax rate

By putting values we have:

Tax = ($20m - $12m - $3m) = $1.75 Million

The cash impact is taken while calculating the Free cash flow. This free cash flow method is also used in IRR, NPV, discounted payback method, etc.

By putting values in the above bold equation, we have:

Free Cash Flow = ($20m - $12m) - $1.75 = $6.25 Million