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 $ 1.9 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $ 16 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):

Earnings Forecast​ ($ million)	1	2	. . .	9	10
Sales revenue	26.00026.000	26.00026.000		26.00026.000	26.00026.000
minus−Cost of goods sold	15.60015.600	15.60015.600		15.60015.600	15.60015.600
equals=Gross profit	10.40010.400	10.40010.400		10.40010.400	10.40010.400
minus−​Selling, ​general, and administrative expenses	1.2801.280	1.2801.280		1.2801.280	1.2801.280
minus−Depreciation	1.6001.600	1.6001.600		1.6001.600	1.6001.600
equals Net operating income	7.5207.520	7.5207.520		7.5207.520	7.5207.520
minus Income tax	2.6322.632	2.6322.632		2.6322.632	2.6322.632
equals Net unlevered income	4.8884.888	4.8884.888		4.8884.888

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 $ 4.888 million per year for ten​ years, the project is worth $ 48.88 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 $ 15 million in working capital upfront​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $ 1.28 million of​ selling, general and administrative expenses to the​ project, but you know that $ 0.64 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 9%​, what is your estimate of the value of the new​ project?

Answer 1

SOLUTION:

EVERY FIGURE IN MILLION DOLLORS

COST OF NEW EQUIPMENT=16

INITIAL WORKING CAPITAL REQUIRED=1.9

SALES FOR EACH YEAR =26

COST OF GOODS SOLD=15.6

GROSS PROFIT=26-15.6

GROSS PROFIT=10.4

SELLING, GENERAL AND ADMINISTATIVE EXPENCE=0.64 (IT IS GIVEN THAT 0.64 WILL BE INCURRED EVEN IF PROJECT IS NOT TAKEN SO WHEN WE CALCULATE CASH FLOWS OF PROJECTS WE ONLY INCLUDE INCREMENTAL CASH FLOWS I.E., THE CASH FLOWS THAT IS HAPPENNING ONLY IF PROJECT IS UNDERTAKEN)

DEPRECIATION=1.6

NET OPERATING INCOME=10.4-0.64-1.6 =8.16

INCOME TAX = 2.632

NET INCOME=8.16-2.632

=5.528

CASH FLOW = NET INCOME+DEPRECIATION-CHANGE IN NET WORKING CAPITAL

a)

CASH FLOW IN YEAR 0= -16-1.9 = -17.9(NEGATIVE SIGN INDICATES CASH OUTFLOW)

ADDED 1.9 BECAUSE THIS WORKING CAPITAL IS NEEDED INITIALLY

CASH FLOW IN YEAR 1TO 9 = 5.28 + 1.6 = $ 6.88

CASH FLOW IN YEAR 10 = 5.28 + 1.6 + 1.9 = 8.78 ( 1.9 IS NET WORKING CAPITAL RETURNED)

b)

WE WILL CALCULATE VALUE OF PROJECT USING NPV

NPV IS SUM OF PRESENT VALUE OF ALL CASH FLOWS

PRESENT VALUE = CASH FLOW /(1+r)ⁿ , WHERE r IS REQUIRED RETURN AND n IS NUMBER OF YEARS

r IS COST OF CAPITAL i.e., 9%

NPV =CF₀ +CF₁/(1+r)¹+CF₂/(1+r)² + ....................+ CF₉/(1+r)⁹ + CF₁₀/(1+r)¹⁰

NPV = - 17.9 + 6.88/(1.09)¹+6.88(1.09)²+....................+6.88/(1.09)⁹ + 8.78(1.09)¹⁰

NPV = 27.0570

THE VALUE OF PROJECT IS 27.0570 MILLION DOLLORS .

  PLEASE VOTEUP!!!!!!!!!!!!!!!!