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 $1.1 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):

	1	2	. . .	9	10
Sales revenue	33.000	33.000		33.000	33.000
−Cost of goods sold	19.800	19.800		19.800	19.800
=Gross profit	13.200	13.200		13.200	13.200
−​General, ​sales, and administrative expenses	1.520	1.520		1.520	1.520
−Depreciation	1.900	1.900		1.900	1.900
=Net operating income	9.780	9.780		9.780	9.780
−Income tax	3.423	3.423		3.423	3.423
=Net income	6.357	6.357		6.357	6.357

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 $6.357 million per year for 10​ years, the project is worth $63.57 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 $1.52 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?

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?

Answer 1

a. What is the Free Cash flow for Years 0 to 10.

The cash flow provided by the consultant is an accounting income statement. For finding out the free cash flow to evaluate the project, relevant costs needs to be considered. The below table shows the Free cash flow for the project from Year 0 to Year 10.

$ in Million	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Sales Revenues		33.000	33.000	33.000	33.000	33.000	33.000	33.000	33.000	33.000	33.000
Less: Cost of Goods sold		19.800	19.800	19.800	19.800	19.800	19.800	19.800	19.800	19.800	19.800
Gross Profit		13.200	13.200	13.200	13.200	13.200	13.200	13.200	13.200	13.200	13.200
Less :General, sales and admin expenses		0.760	0.760	0.760	0.760	0.760	0.760	0.760	0.760	0.760	0.760
Less: Depreciation		4.275	6.626	3.644	2.004	1.102	0.606	0.333	0.183	0.101	0.055
Net Operating Income		8.165	5.814	8.796	10.436	11.338	11.834	12.107	12.257	12.339	12.385
Less: Income tax @ 35%		2.858	2.035	3.078	3.652	3.968	4.142	4.237	4.290	4.319	4.335
Net Income		5.307	3.779	5.717	6.783	7.369	7.692	7.869	7.967	8.020	8.050
Add: Depreciation		4.275	6.626	3.644	2.004	1.102	0.606	0.333	0.183	0.101	0.055
Cash flow from machine -A		9.582	10.405	9.362	8.788	8.472	8.298	8.203	8.150	8.121	8.105
Purchase of the machine - B	(19.000)
Working capital - C	(8.000)										8.000
Free Cash flow - A+B+C	(27.000)	9.582	10.405	9.362	8.788	8.472	8.298	8.203	8.150	8.121	16.105

Note:

1) General, sales and admin expenses - Only $760,000 should considered. The balance $760,000 is irrelevant for the project as it will be incurred whether the project is proceeded or not.

2) Income tax is arrived at based on the given income statement. Income tax = tax paid/pretax profit = 3.129/8.940 =35%

3) The consltant fee of $1.1 million is a sunk cost and hence not relevant for the project.

4) Depreciation is calculated on the following basis -

$ in Million	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Asset cost (opening bal)	19.000	14.725	8.099	4.454	2.450	1.347	0.741	0.408	0.224	0.123
Less: Depreciation @ 45%	4.275	6.626	3.644	2.004	1.102	0.606	0.333	0.183	0.101	0.055
Closing balance	14.725	8.099	4.454	2.450	1.347	0.741	0.408	0.224	0.123	0.068

Depreciation for first year will be 50% of the actual depreciation rate (45%*50%).