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

$ 1.4$1.4

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

$ 21$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	32.00032.000	32.00032.000		32.00032.000	32.00032.000
minus−Cost of goods sold	19.20019.200	19.20019.200		19.20019.200	19.20019.200
equals=Gross profit	12.80012.800	12.80012.800		12.80012.800	12.80012.800
minus−​General, ​sales, and administrative expenses	1.6801.680	1.6801.680		1.6801.680	1.6801.680
minus−Depreciation	2.1002.100	2.1002.100		2.1002.100	2.1002.100
equals=Net operating income	9.0209.020	9.0209.020		9.0209.020	9.0209.020
minus−Income tax	3.1573.157	3.1573.157		3.1573.157	3.1573.157
equals=Net income	5.8635.863	5.8635.863		5.8635.863	5.8635.863

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 %30%

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

$ 5.863$5.863

million per year for 10​ years, the project is worth

$ 58.63$58.63

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

$ 11$11

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

$ 1.68$1.68

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

$ 0.84$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!

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?

*numbers got repeated for some reason(just one of the number)

Answer 1

Operating cash flow (OCF) each year = income after tax + depreciation

Depreciation in Year 1 = cost of equipment * CCA rate / 2

Depreciation in Years 2 to 9 = book value at beginning of year * CCA rate

Depreciation in Year 10 = remaining book value of equipment

Book value of equipment at end of each year = book value at beginning of year - depreciation

Tax rate = income tax / net operating income = $3.157 million / $9.020 million = 35%

The amount of $1.4 million paid to consultants is a sunk cost, and should not be considered in the cash flow analysis.

Out of the overhead expenses, $0.84 million should not be considered because it is not an incremental cash flow.

The cash flows are calculated as below ;