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 $ 28.3 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 $ 4.554 million per year for ten​ years, the project is worth $ 45.54 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 $ 13.9 million in net working capital up front​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $ 2.264 million of​ selling, general and administrative expenses to the​ project, but you know that $ 1.132 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 15 %​, what is your estimate of the value of the new​ project?

29.000 17.400 11.600 Earnings forecast Sales revenue - Cost of goods sold = Gross profit - General, sales and administrative expenses - Depreciation = Net operating profit - Income tax = Net profit Project year 9 29.000 29.000 17.400 17.400 11.600 11.600 2.264 2.264 2.830 2.830 6.506 6.506 1.952 1.952 4.554 4.554 10 29.000 17.400 11.600 2.264 2.830 6.506 1.952 4.554 2.830 6.506 1.952 4.554

Answer 1

			Present Value(PV) of Cash Flow:
			(Cash Flow)/((1+i)^N)
			i=discount rate=Cost of capital=15%=0.15
			N=Year   of Cash Flow
			Cash Flow in Year 0
		A	Cost of new equipment	-$28.30	million
		B	Net Working Capital	-$13.90	million
		C=A+B	Total Initial Cash Flow	-$42.20	million
			Cash Flow in Year 1-9
		D	Net Operating Profit calculated by the consultants	$6.506	million
		E	Add: Overestimation of general expenses	$1.132	million
		F=D+E	Operating Profit before taxes	$7.638	million
		G=F*30%	Taxes	$2.291	million	(1.952/6.506)=	0.3	30%
		H=F-G	Net Operating Profit	$5.347	million
		I	Add : Annual Depreciation (Non cash expense)	$2.830	million
		J=H+I	Cash Flow in Year 1-9	$8.177	million
		K	Release of initial net working capital	$13.900	million
		L=J+K	Cash Flow in Year 10	$22.077	million
			N=Year   of Cash Flow
		N	Year	0	1	2	3	4	5	6	7	8	9	10
		CF	Net Cash Flow	-$42.200	$8.177	$8.177	$8.177	$8.177	$8.177	$8.177	$8.177	$8.177	$8.177	$22.077	SUM
		PV=CF/(1.15^N)	Present Valure	-$42.200	$7.110	$6.183	$5.376	$4.675	$4.065	$3.535	$3.074	$2.673	$2.324	$5.457	$2.272
		NPV=Sum of PV	Net Present Value	$2.272	million
		b	Estimated Value of the new project	$2.272	million