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 $24 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	28.000	28.000		28.000	28.000
?Cost of goods sold	16.800	16.800		16.800	16.800
=Gross profit	11.200	11.200		11.200	11.200
??General, ?sales, and administrative expenses	1.920	1.920		1.920	1.920
?Depreciation	2.400	2.400		2.400	2.400
=Net operating income	6.8800	6.8800		6.8800	6.8800
?Income tax	2.408	2.408		2.408	2.408
=Net income	4.472	4.472		4.472	4.472

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. Canada Revenue Agency allows a CCA rate of 30 % on the equipment for tax purposes. The report concludes that because the project will increase earnings by $ 4.472 million per year for ten? years, the project is worth $ 44.72 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 $ 14 million in working capital up front? (year 0), which will be fully recovered in year 10.? Next, you see they have attributed $ 1.92 million of?selling, general and administrative expenses to the? project, but you know that $ 0.96 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 10 %?, what is your estimate of the value of the new? project?

Appreciate the help on this question.

Answer 1

Free cash flow = EBIT*(1-Tax) +Dep. - Cap Ex - change in WC

PFA the snippet for the present value.

SG&A	0.9	Mn
		1	2	3	4	5	6	7	8	9	10
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Earnings Forecast
Sales Revenue		28	28	28	28	28	28	28	28	28	28
COGS		16.8	16.8	16.8	16.8	16.8	16.8	16.8	16.8	16.8	16.8
Gross Profit		11.2	11.2	11.2	11.2	11.2	11.2	11.2	11.2	11.2	11.2
SG&A		0.9	0.9	0.9	0.9	0.9	0.9	0.9	0.9	0.9	0.9
Depreciation		2.4	2.4	2.4	2.4	2.4	2.4	2.4	2.4	2.4	2.4
Net Operating Income		7.78	7.78	7.78	7.78	7.78	7.78	7.78	7.78	7.78	7.78
Income Tax		2.408	2.408	2.408	2.408	2.408	2.408	2.408	2.408	2.408	2.408
Net Income		4.472	4.472	4.472	4.472	4.472	4.472	4.472	4.472	4.472	4.472
FCFF		7.846	7.846	7.846	7.846	7.846	7.846	7.846	7.846	7.846	7.846
PV of FCFF		7.133	6.484	5.895	5.359	4.872	4.429	4.026	3.660	3.327	3.025
PV of total cash flows	48.21
Initial Investment	-14	Mn
Net Present Value	34.21	Mn