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 $ 1.1 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $19 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):

	Project Year
Earnings Forecast ($000,000s)	1	2	. . .	9	10
Sales revenue	28	28		28	28
- Cost of goods sold	16.8	16.8		16.8	16.8
Gross profit	11.2	11.2		11.2	11.2
- Selling, general, and administrative expenses	1.52	1.52		1.52	1.52
- Depreciation	1.9	1.9		1.9	1.9
Net operating income	7.78	7.78		7.78	7.78
- Income tax	2.723	2.723		2.723	2.723
Net unlevered income	5.057	5.057		5.057	5.057

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 $5.057 million per year for ten​ years, the project is worth $ 50.57 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 $12 million in working capital upfront​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $ 1.52 million of​ selling, general and administrative expenses to the​ project, but you know that $ 0.76 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 8%​ what is your estimate of the value of the new​ project?

Answer 1

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