Question

uou 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

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

$ 21 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):

	1	2	. . .	9	10
Sales revenue	29.000	29.000		29.000	29.000
minus−Cost of goods sold	17.400	17.400		17.400	17.400
equals=Gross profit	11.600	11.600		11.600	11.600
minus−​General, ​sales, and administrative expenses	1.680	1.680		1.680	1.680
minus−Depreciation	2.100	2.100		2.1002.100	2.100
equals=Net operating income	7.8200	7.8200		7.8200	7.8200
minus−Income tax	2.737	2.737		2.737	2.737
equals=Net income	5.083	5.083		5.083	5.083

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

20 % on the equipment for tax purposes. The report concludes that because the project will increase earnings by

$ 5.083 million per year for ten​ years, the project is worth

$ 50.83 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

$ 14 million in working capital up front​ (year 0), which will be fully recovered in year 10. Next you see they have attributed

$ 1.68 million of​ selling, general and administrative expenses to the​ project, but you know that

$ 0.84 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 16 %

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

Answer 1

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