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

$1.7

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

$26.8

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	1	2	. . .	9	10
Sales Revenue	30.000	30.000		30.000	30.000
−Cost of Goods Sold	18.000	18.000		18.000	18.000
=Gross Profit	12.000	12.000		12.000	12.000
−​General, Sales and Administrative Expenses	2.144	2.144		2.144	2.144
−Depreciation	2.680	2.680		2.680	2.680
=Net Operating Income	7.176	7.176		7.176	7.176
−Income Tax	2.512	2.512		2.512	2.512
=Net Income	4.664	4.664		4.664	4.664

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. They also calculated the depreciation assuming no salvage value for the equipment. The report concludes that because the project will increase earnings by

$4.664

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

$46.64

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 included the fact that the project will require

$14.3

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

$2.144

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

$1.072

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

12%​,

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

Answer 1

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