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 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $29 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
−Cost of goods sold	17.400	17.400		17.400	17.400
=Gross profit	11.600	11.600		11.600	11.600
−​General, ​sales, and administrative expenses	2.320	2.320		2.320	2.320
−Depreciation	2.900	2.900		2.900	2.900
=Net operating income	6.3800	6.3800		6.3800	6.3800
−Income tax	2.233	2.233		2.233	2.233
=Net income	4.147	4.147		4.147	4.147

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

45% on the equipment for tax purposes. The report concludes that because the project will increase earnings by $4.147 million per year for ten​ years, the project is worth $41.47 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 $15 million in working capital up front​ (year 0), which will be fully recovered in year 10. Next you see they have attributed

$2.32 million of​ selling, general and administrative expenses to the​ project, but you know that $1.16 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 11%​, what is your estimate of the value of the new​ project?

Answer 1

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

Depreciation in subsequent years = book value of equipment * CCA rate

Depreciation in Year 10 = remaining book value

SGA expenses attributed to this project = $2.32 million - $1.16 million = $1.16 million

Tax rate = income tax / net operating income = $2.233 / $6.38 = 35%

Free cash flow (FCF) is calculated as below :

Year 1 = -(cost of equipment + investment in working capital)

Years 2 to 9 = net income + depreciation

Year 10 = net income + depreciation + recovery of working capital

The amount payable to consultants is a sunk cost, and therefore should not be included in the cash flows.

NPV = sum of present values of all cash inflows – initial investment

NPV is calculated using NPV function in Excel

NPV is $9.002 million