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 million for this​ report, and I am not sure their analysis makes sense. Before we spend the 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	1	2	. . .	9	10
Sales revenue	25.000	25.000		25.000	25.000
−Cost of goods sold	15.000	15.000		15.000	15.000
=Gross profit	10.000	10.000		10.000	10.000
−​General, sales and administrative expenses	1.376	1.376		1.376	1.376
−Depreciation	1.720	1.720		1.720	1.720
=Net operating profit	6.904	6.904		6.904	6.904
−Income tax	2.071	2.071		2.071	2.071
=Net profit	4.833	4.833		4.833	4.833

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 $4.833 million per year for ten​ years, the project is worth $48.33 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 $8.9 million in net working capital up front​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $1.376 million of​ selling, general and administrative expenses to the​ project, but you know that $0.688 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 9%​, what is your estimate of the value of the new​ project?

a. The free cash flow for year 0 is $ ................ million.  ​(Round to three decimal​ places.)

The free cash flow for years 1 to 9 is ​$ ................ million.  ​(Round to three decimal​ places.)

The free cash flow for year 10 is $ ................ million.  ​(Round to three decimal​ places.)

b. If the cost of capital for this project is 9%​, the value of project is $ ................ million.  ​(Round to three decimal​ places.)

You (should/should not) accept the project.​ (Choose the best answer from the brackets.)

Answer 1

a. The free cash flow for year 0 is -$57.230 million.  ​(Round to three decimal​ places.)

The free cash flow for years 1 to 9 is ​$7.034 million.  ​(Round to three decimal​ places.)

The free cash flow for year 10 is $15.934 million.  ​(Round to three decimal​ places.)

b. If the cost of capital for this project is 9%​, the value of project is -$8.326 million.  ​(Round to three decimal​ places.)

You should not accept the project.​ (Choose the best answer from the brackets.)