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 $1.3million for this​ report, and I am not sure their analysis makes sense. Before we spend the $ 27million 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):

	1	2	. . .	9	10
Sales revenue	35.000	35.000		35.000	35.000
minus−Cost of goods sold	21.000	21.000		21.000	21.000
equals=Gross profit	14.000	14.000		14.000	14.000
minus−​General, ​sales, and administrative expenses	2.160	2.160		2.160	2.160
minus−Depreciation	2.700	2.700		2.700	2.700
equals=Net operating income	9.1400	9.1400		9.1400	9.1400
minus−Income tax	3.199	3.199		3.199	3.199
equals=Net income	5.941	5.941		5.941	5.941

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. CRA allows a CCA rate of 30 %on the equipment for tax purposes. The report concludes that because the project will increase earnings by$ 5.941 million per year for ten​ years, the project is worth$ 59.41million. 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 $ 9

million in working capital up front​ (year 0), which will be fully recovered in year 10. Next you see they have attributed $2.16 million of​ selling, general and administrative expenses to the​ project, but you know that $1.08million 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 8%​,what is your estimate of the value of the new​ project?

value of project= ?

Answer 1