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 $1.3 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $18 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	26.000	26.000		26.000	26.000
minus−Cost of goods sold	15.600	15.600		15.600	15.600
equals=Gross profit	10.400	10.400		10.400	10.400
minus−​General, ​sales, and administrative expenses	1.440	1.440		1.440	1.440
minus−Depreciation	1.800	1.800		1.800	1.800
equals=Net operating income	7.1600	7.1600		7.1600	7.1600
minus−Income tax	2.506	2.506		2.506	2.506
equals=Net income	4.654	4.654		4.654	4.654

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 $4.654 million per year for ten​ years, the project is worth $46.54 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 $8 million in working capital up front​ (year 0), which will be fully recovered in year 10. Next you see they have attributed $1.44 million of​ selling, general and administrative expenses to the​ project, but you know that $0.72 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 9%​, what is your estimate of the value of the new​ project?

Answer 1

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