Question

You are a manager at Advanced Plastics, which is considering expanding its operations into 3D manufacturing. Your boss comes into your office, drops a consultant's report on your desk, and complains, “We owe these consultants $1.5 million for this report, and I am not sure their analysis makes sense. Before we spend the $30 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 thousands of dollars): Year 1 Year 2 Year 9 Year 10 Sales $ 40,000 $ 40,000 ... $ 40,000 $ 40,000 - COGS $ 28,000 $ 28,000 $ 28,000 $ 28,000 = Gross Profit $ 12,000 $ 12,000 12,000 $ 12,000 - General and Admin. Exp. $ 3,000 $ 3,000 3,000 $ 3,000 - Depreciation 3,000 3,000 3,000 3,000 = Net Operating Income $ 6,000 $ 6,000 ... $ 6,000 $ 6,000 - Taxes 2,400 2,400 2,400 2,400 Net Income $ 3,600 $ 3,600 ... $ 3,600 $ 3,600 AA 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. The report concludes that because the project will increase earnings by $3.6 million per year for 10 years, the project is worth $36 million, more than the cost of the equipment required. You think back to your halcyon days in finance class and realize there is more work to be done! First, you note that the consultants have not factored in the fact that the project will require $15 million in working capital up-front (year 0), which will be fully recovered in year 10. Next, you see they have attributed $3 million of general and administrative expenses to the project, but you know that $2 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 on which to focus. Given the available information, calculate the free cash flows for the proposed project and estimate its value using a 16 percent weighted average cost of capital. Should your firm undertake this project?

Answer 1

Please find the below solution

Solution Intial Cash Outflows New Equipment Working Capital Total $ 30 Million $ 15 Million $45 Million Free Cash Flows Sales -COGS G/P -General Admin OH -Depreciation Net Operating Income -Taxes @40% Net Income Add : Depreciation Free Cash Flows Discount Factor @16% Discounted Cash Flow Y-1 Y-2 Y-3 $40,000 $40,000 $40,000 $28,000 $28,000 $28,000 $12,000 $12,000 $12,000 $1,000 $1,000 $1,000 $3,000 $3,000 $3,000 $8,000 $8,000 $8,000 $3,200 $3,200 $3,200 $4,800 $4,800 $4,800 $3,000 $3,000 $3,000 $7,800 $7,800 $7,800 0.8621 0.7432 0.6407 6,724 $ 5,797 $ 4,997 Y-4 $40,000 $28,000 $12,000 $1,000 $3,000 $8,000 $3,200 $4,800 $3,000 $7,800 0.5523 $ 4,308 Y-5 $40,000 $28,000 $12,000 $1,000 $3,000 $8,000 $3,200 $4,800 $3,000 $7,800 0.4761 $ 3,714 Y-6 $40,000 $28,000 $12,000 $1,000 $3,000 $8,000 $3,200 $4,800 $3,000 $7,800 0.4104 $ 3,201 Y-7 Y-8 Y-9 Y-10 $40,000 $40,000 $40,000 $40,000 $28,000 $28,000 $28,000 $28,000 $12,000 $12,000 $12,000 $12,000 $1,000 $1,000 $1,000 $1,000 $3,000 $3,000 $3,000 $3,000 $8,000 $8,000 $8,000 $8,000 $3,200 $3,200 $3,200 $3,200 $4,800 $4,800 $4,800 $4,800 $3,000 $3,000 $3,000 $3,000 $7,800 $7,800 $7,800 $7,800 0.3538 0.3050 0.2630 0.2267 $ 2,760 $ 2,379 $ 2,051 $ 1,768 $ Total $ 37,699 Decision A) Cash outflow in YO = $ 45 Million B) PV of Cash Inflow = $ 37.70 Millon Since A > B, Project Cannot be accepted Other Notes Intial working capital investment is not considered by consultants should be considered Genereal Admin overhead relating to project only to be considered Tax rate is calculated on the basis of Question Depreciation calcualted on SLM Basis Depreciation is not actually cash outflow hence to be added back to net income Cash flow to be discounted using WACC