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​ complains, "We owe these consultants $1.6 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $23 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​ ($ million)	1	2	. . .	9	10
Sales revenue	30.00030.000	30.00030.000		30.00030.000	30.00030.000
minus−Cost of goods sold	18.00018.000	18.00018.000		18.00018.000	18.00018.000
equals=Gross profit	12.00012.000	12.00012.000		12.00012.000	12.00012.000
minus−​Selling, ​general, and administrative expenses	1.8401.840	1.8401.840		1.8401.840	1.8401.840
minus−Depreciation	2.3002.300	2.3002.300		2.3002.300	2.3002.300
equals=Net operating income	7.8607.860	7.8607.860		7.8607.860	7.8607.860
minus−Income tax	2.7512.751	2.7512.751		2.7512.751	2.7512.751
equals=Net unlevered income	5.1095.109	5.1095.109		5.1095.109	5.1095.109

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 $5.109 million per year for ten​ years, the project is worth $51.09 million. 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 $14 million in working capital upfront​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $1.84 million of​ selling, general and administrative expenses to the​ project, but you know that $0.92 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 through 10 that should be used to evaluate the proposed​ project?

b. If the cost of capital for this project is 16%​,

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

Given the available​ information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed​ project?

The free cash flow for year 0 is ​$____million. ​ (Round to three decimal places and enter a decrease as a negative​ number.)

The free cash flow for years 1 to 9 is ​$_____million. ​(Round to three decimal places and enter a decrease as a negative​ number.)

The free cash flow for year 10 is ​$____million. ​ (Round to three decimal places and enter a decrease as a negative​ number.)

b. If the cost of capital for this project is 16 %

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

The value of the project is ​$____million. ​ (Round to three decimal​ places.)

Answer 1

The free cash flow for year 0 is - $ 37 million.

The free cash flow for years 1 to 9 is ​ $ 8.007 million.

The free cash flow for year 10 is ​ $22.007 million. ​

The value of the project is ​$4.873 million.