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$1.6

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

$ 20$20

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):  ​(Click on the following icon

  

in order to copy its contents into a​ spreadsheet.)

	Project Year
Earnings Forecast​ ($ million)	1	2	. . .	9	10
Sales revenue	25.00025.000	25.00025.000		25.00025.000	25.00025.000
minus−Cost of goods sold	15.00015.000	15.00015.000		15.00015.000	15.00015.000
equals=Gross profit	10.00010.000	10.00010.000		10.00010.000	10.00010.000
minus−​Selling, ​general, and administrative expenses	1.6001.600	1.6001.600		1.6001.600	1.6001.600
minus−Depreciation	2.0002.000	2.0002.000		2.0002.000	2.0002.000
equals=Net operating income	6.4006.400	6.4006.400		6.4006.400	6.4006.400
minus−Income tax	1.281.28	1.281.28		1.281.28	1.281.28
equals=Net unlevered income	5.1205.120	5.1205.120		5.1205.120	5.1205.120

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

$ 5.120$5.120

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

$ 51.2$51.2

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

$ 11$11

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

$ 1.6$1.6

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

$ 0.8$0.8

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 %16%​,

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

Answer 1

ALL FIGURES ARE ROUNDED TO 3 DECIMALS. SO NPV = 8.999

IF WE ROUND TO 2 DECIMALS, IT WILL BE 9 MILLION