Question

You are a manager at Percolated​ Fibre, which is considering expanding its operations in synthetic fibre manufacturing. Your boss comes into your​ office, drops a​ consultant's report on your​ desk, and​ complains, "We owe these consultants $ 1.7 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $ 25.6 million on new equipment needed for this​ project, look it over and give me your​ opinion." You open the report and find the following estimates​ (in millions of​ dollars):

Click on the Icon located on the​ top-right corner of the data table below in order to copy its information into a spreadsheet.

All of the estimates in the report seem correct. You note that the consultants used​ straight-line depreciation for the new equipment that will be purchased today​ (year 0), which is what the accounting department recommended. They also calculated the depreciation assuming no salvage value for the​ equipment, which is the​ company's assumption in this case. The report concludes that because the project will increase earnings by $ 6.294 million per year for ten​ years, the project is worth $ 62.94 million. You think back to your glory days in finance class and realise there is more work to be​ done!

​First, you note that the consultants have not factored in the fact that the project will require $ 9.5 million in net working capital up front​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $ 2.048 million of​ selling, general and administrative expenses to the​ project, but you know that $ 1.024 million of this amount is overhead that will be incurred even if the project is not accepted.​ Finally, you know that accounting earnings are not the right thing to focus​ on!

a. Given the available​ information, what are the free cash flows in years 0 to 10 that should be used to evaluate the proposed​ project?

b. If the cost of capital for this project is 13 %​, what is your estimate of the value of the new​ project?

10 Earnings forecast Sales revenue - Cost of goods sold = Gross profit - General, sales and administrative expenses - Depreciation = Net operating profit - Income tax = Net profit 34.000 20.400 13.600 2.048 2.560 8.992 2.698 6.294 Project year 2 ... 34.000 20.400 13.600 2.048 2.560 8.992 2.698 6.294 34.000 20.400 13.600 2.048 2.560 8.992 2.698 6.294 34.000 20.400 13.600 2.048 2.560 8.992 2.698 6.294

Answer 1

As per the given information

1. "$ 2.048 million of​selling, general and administrative expenses to the​ project, but you know that $ 1.024 million of this amount is overhead that will be incurred even if the project is not accepted.​"

General, sales and administrative expenses = 2.048 -1.024 = 1.024 should be counted in cash flow for project.

2."the project will require $ 9.5 million in net working capital up front​ (year 0), which will be fully recovered in year 10"

The initial cash flow will be increase by 9.5 million and same will be add back in cash flow of 10th year.

Answer a)

Year	0	1	2	3	4	5	6	7	8	9	10
Cost of Equipment	-$25.600
Working capital	-$9.500
Total Cost	-$35.100
Sale Revenue		$34.000	$34.000	$34.000	$34.000	$34.000	$34.000	$34.000	$34.000	$34.000	$34.000
cost of goods sold		-$20.400	-$20.400	-$20.400	-$20.400	-$20.400	-$20.400	-$20.400	-$20.400	-$20.400	-$20.400
gross Profit		$13.600	$13.600	$13.600	$13.600	$13.600	$13.600	$13.600	$13.600	$13.600	$13.600
General expenses		-$1.024	-$1.024	-$1.024	-$1.024	-$1.024	-$1.024	-$1.024	-$1.024	-$1.024	-$1.024
Depreciation		-$2.560	-$2.560	-$2.560	-$2.560	-$2.560	-$2.560	-$2.560	-$2.560	-$2.560	-$2.560
net operating profit		$10.016	$10.016	$10.016	$10.016	$10.016	$10.016	$10.016	$10.016	$10.016	$10.016
income tax		-$2.698	-$2.698	-$2.698	-$2.698	-$2.698	-$2.698	-$2.698	-$2.698	-$2.698	-$2.698
net profit		$7.318	$7.318	$7.318	$7.318	$7.318	$7.318	$7.318	$7.318	$7.318	$7.318
add depreciation		$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560
add return of working capital		$0.000	$0.000	$0.000	$0.000	$0.000	$0.000	$0.000	$0.000	$0.000	$9.500
Free cash flow from project	-$35.100	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$12.060

Answer b)

Year	0	1	2	3	4	5	6	7	8	9	10
Free cash flow from project	-$35.100	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$2.560	$12.060
Cost of capital	13%
PV of free cash flow	-$35.10	$2.27	$2.00	$1.77	$1.57	$1.39	$1.23	$1.09	$0.96	$0.85	$3.55
Value of project (estimated)	$16.69
Net value of project (NPV)	-$18.41