Question

You are a manager at Northern​ 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

$ 1.9

million for this​ report, and I am not sure their analysis makes sense. Before we spend the

$ 28

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):

	Project Year
Earnings Forecast​ ($000,000s)	1	2	. . .	9	10
Sales revenue	26.00026.000	26.00026.000		26.00026.000	26.00026.000
minus−Cost of goods sold	15.60015.600	15.60015.600		15.60015.600	15.60015.600
equals=Gross profit	10.40010.400	10.40010.400		10.40010.400	10.40010.400
minus−​General, ​sales, and administrative expenses	2.2402.240	2.2402.240		2.2402.240	2.2402.240
minus−Depreciation	2.8002.800	2.8002.800		2.8002.800	2.8002.800
equals=Net operating income	5.36005.3600	5.36005.3600		5.36005.3600	5.36005.3600
minus−Income tax	1.8761.876	1.8761.876		1.8761.876	1.8761.876
equals=Net income	3.4843.484	3.4843.484		3.4843.484	3.4843.484

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 for financial reporting purposes. Canada Revenue Agency allows a CCA rate of

45 %

on the equipment for tax purposes. The report concludes that because the project will increase earnings by

$ 3.484

million per year for ten​ years, the project is worth

$ 34.84

million. You think back to your glory 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

$ 13

million in working capital up front​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed

$ 2.24

million of​ selling, general and administrative expenses to the​ project, but you know that

$ 1.12

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!b. If the cost of capital for this project is

10 %

what is your estimate of the value of the new​ project?

b. If the cost of capital for this project is

10

what is your estimate of the value of the new​ project?

Answer 1

At 10% of cost of capital, value of the project is $7.1646 million

Solution displayed below: