Question

You are a manager at Percolated? 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 $ 1.7million for this? report, and I am not sure their analysis makes sense. Before we spend the $22.2million 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 YEARS

EARNINGS FORECAST	1	2	...	9	10
SALES REVENUE	26000	26000		26000	26000
COST OF GOODS SOLD	15600	15600		15600	15600
=GROSS PROFIT	10400	10400		10400	10400
-GENERAL, SALES AND ADMINISTRATION EXPENSES	1776	1776		1776	1776
-DEPRECIATION	2220	2220		2220	2220
=NET OPERATING PROFIT	6404	6404		6404	6404
-INCOME TAX	1921	1921		1921	1921
=NET PROFIT	4483	4483		4483	4483

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, which is the? company's assumption in this case. The report concludes that because the project will increase earnings by $ 4.483million per year for ten? years, the project is worth $ 44.83 million. You think back to your glory days in finance class and realise there is more work to be? done!First, you note that the consultants have not factored in the fact that the project will require $ 9.3million in net working capital up front? (year 0), which will be fully recovered in year 10.? Next, you see they have attributed $ 1.776million of? selling, general and administrative expenses to the? project, but you know that $ 0.88 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 to 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

Formula sheet

A	B	C	D	E	F	G	H	I	J	K
2
3		a)
4		Free cash flow can be calculated as follows:
5		Free Cash Flow = Operating Cash Flow - Capital Expenditures - Change in working capital
6		Operating Cash Flow = EBIT*(1-Tax Rate)+Depreciation
7		Tax Rate	=1921/6404	=1921/6404
8
9		Year	0	1	2	...	9	10
10		Sales Revenue		26000	26000	26000	26000	26000
11		Less : Cost of Goods Sold		15600	15600	15600	15600	15600
12		Gross Profit		=E10-E11	=F10-F11	=G10-G11	=H10-H11	=I10-I11
13		Less : General Sales and Administration		=1776-880	=1776-880	=1776-880	=1776-880	=1776-880
14		Less : Depreciation		2220	2220	2220	2220	2220
15		Net Operating income		=E12-E13-E14	=F12-F13-F14	=G12-G13-G14	=H12-H13-H14	=I12-I13-I14
16		Less : Income Tax		=E15*$D$7	=F15*$D$7	=G15*$D$7	=H15*$D$7	=I15*$D$7
17		After -Tax Operating Profit		=E15-E16	=F15-F16	=G15-G16	=H15-H16	=I15-I16
18		Add: Depreciation		=E14	=F14	=G14	=H14	=I14
19		Operating Cash Flow		=E17+E18	=F17+F18	=G17+G18	=H17+H18	=I17+I18
20		Initial Investment in Equipment	-22200
21		Investment in Working Capital	-9300					=-D21
22		Free Cash Flow	=D20+D21	=E19	=F19	=G19	=H19	=I19+I21
23
24
25		b)
26
27		NPV of the project is present value of future cash flows discounted at required rate of return less the initial investment.
28
29		Year	0	1	2	...	9	10
30		Free Cash Flow (FCF)	=D22	=E22	=F22	=G22	=H22	=I22
31		MARR (i)	0.08
32
33		Net Present value	=-$31,500 + 7319*(P/A,8%,10)+($16,619-$7,319)*(P/F,8%,10)
34			=-31500 + 7319*PV(D31,10,-1,0)+(16619-7319)*(1/((1+D31)^10))	=-31500 + 7319*PV(D31,10,-1,0)+(16619-7319)*(1/((1+D31)^10))
35
36		Hence value of the new project is	=D34/1000	million
37