Question

You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office drops a consultant's report on your desk, and complaints owe these consultants $1.4 million for this report and I am not sure the analysis makes sense. Before we spend the $248 milion on new equipment needed for this project, look over and give me your opinion." You open the report and find the following ustimates in milions of dollars Project Year Earnings Forecast Sales Revenue 27.000 27.000 27000 27 000 - Cost of Goods Sold 16.200 16.200 15 200 16200 Gross Profit 10 800 10.800 10.800 10.800 - General, Sales and Administrative Expenses 1.984 1984 1984 1.584 -Depreciation 2.480 2480 2.480 2.480 Net Operating income 0.336 6.300 6.336 - Income Tax 2218 2.218 2218 2.218 All of the estimates in the report sem correct Youle that the consultantsused straight line depreciation for the new equipment that will be purchased today yearl which is what the accounting department recommended. They also calculated the depreciation assuming no salvage value for the equipment. The report concludes that because the project will increase ings by 84.116 milion per year for 10 years, the project is worth 541 18 milion. You think back to your glory days in france class and realize there is more work to be done! First, you note that the consultants have not included the fact that the project will require $13.3 milion in working capital up front year, which will be fully recovered in year 10 Next, you see they have tributed $1.004 milion of in general and administrative expenses to the but you know that $0.992 milion of this amount is overhead that will be incurred even if the projects not accepted. Finally, you know that accounting wings are not the thing to focus on! a. Given the available information, what are the free cash flows in years through 10 that should be used to evaluate the proposed Dot b. the cost of capital for this project is 13%, what is your estimate of the value of the new po ? a. Oven the available information, what are the free cash flows in years through 10 that should be used to evaluate the proposed project? The free cash flow for years 5 -38.100 million (Round to the decimal places.) The free cash flow for years 1 to 9 5 milion Round to three decimal places) The free cash flow for your 10 is $ million (Round to three decimal places) br the cost of capital for this project is 13% what is your estimate of the value of the new project? Ythe cost of capital for this project is 13% the value of the project is $ million Round to three decimal places) You (1) - accept the project. Choose from the drop-down menu.) (1) should O should not

Answer 1

a]

FCF in year 0 = -(cost of equipment + investment in working capital)

FCF in years 1 to 9 = incremental earnings after tax + depreciation

In computing incremental earnings, only the incremental SGA expenses must be considered, and the $0.992 million of overhead should not be considered because they would be incurred even if the project is not accepted.

Tax rate = income tax / net operating income = $2.218 / $6.336

FCF in year 10 = incremental earnings after tax + depreciation + recovery of investment in working capital

FCF in year 0 = -$38.100 million

FCF in years 1 to 9 = $9.461 million

FCF in year 10 = $22.761 million

b]

Value of project is its NPV

NPV is calculated using NPV function in Excel

NPV is $19.170 million

Yes, you should accept the project as the NPV is positive

B C D E F G H J K L M 101 2 Initial Investment 3 Cost of equipment 4 Investment in working capital $24.800 $13.300 5 6 OCF 7 Revenues 8 - COGS 9 Gross Profit 10 - SGA expense 11 - Depreciation 12 Incremental earnings before tax 13 - Taxes 14 Income after tax 15 + Depreciation 16 OCF 17 18 Terminal Cash Flow 19 Recovery of working capital 20 21 NPV Analysis 22 FCF 23 24 NPV $27.000 $27.000 $27.000 $27.000 $27.000 $27.000 $27.000 $27.000 $27.000 $27.000 $27.000 $16.200 $16.200 $16.200 $16.200 $16.200 $16.200 $16.200 $16.200 $16.200 $16.200 $16.200 $10.800 $10.800 $10.800 $10.800 $10.800 $10.800 $10.800 $10.800 $10.800 $10.800 $10.800 $0.992 $0.992 $0.992 $0.992 $0.992 $0.992 $0.992 $0.992 $0.992 $0.992 $0.992 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $7.328 $7.328 $7.328 $7.328 $7.328 $7.328 $7.328 $7.328 $7.328 $7.328 $7.328 $0.347 $0.347 $0.347 $0.347 $0.347 $0.347 $0.347 $0.347 $0.347 $0.347 $0.347 $6.981 $6.981 $6.981 $6.981 $6.981 $6.981 $6.981 $6.981 $6.981 $6.981 $6.981 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $2.480 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $13.300 ($38.100) $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $9.461 $22.761 $19.170