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 $ 1.1 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $ 21.7 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	1	2	. . .	9	10
Sales Revenue	26	26		26	26
- Cost of Goods Sold	15.6	15.6		15.6	15.6
Gross Profit	10.4	10.4		10.4	10.4
- General, Sales and Administrative expenses	1.736	1.736		1.736	1.736
- Depreciation	2.17	2.17		2.17	2.17
Net Operating Income	6.494	6.494		6.494	6.494
- Income Tax	2.273	2.273		2.273	2.273
Net Income	4.221	4.221		4.221	4.221

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 $ 4.221 million per year for 10​ years, the project is worth $ 42.1 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 $ 1.736 million of​ selling, general, and administrative expenses to the​ project, but you know that $ 0.868 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?

Answer 1

a) The free cash from 0 to 10 years are calculated are as follows-

(in million of dollars)

Earning Forecast	0	1	2	,,,	9	10
Cost of new equipment	(21.7)
Change in Working Capital	(14.3)					14.3
Sales Revenue		26	26		26	26
- Cost of Goods Sold		15.6	15.6		15.6	15.6
Gross Profit		10.4	10.4		10.4	10.4
-General Sales & Adm. Expenses		0.868	0.868		0.868	0.868
- Depreciation		2.17	2.17		2.17	2.17
Net operating Income		7.362	7.362		7.362	7.362
- Income Tax		2.5767	2.5767		2.5767	2.5767
Net Income (A)		4.7853	4.7853		4.7853	4.7853
Depreciation (B)		2.17	2.17		2.17	2.17
Cash flows (A+B)		6.9553	6.9553		6.9553	6.9553
Cost of Machine plus change in Net Working Capital (C)	(36)					14.3
Total Cash Flows (A+B+C)	(36)	6.9553	6.9553		6.9553	21.2553

b) If the cost of Capital is 10%, the estimated value of project is calculated as follows -

= -36+6.9553*5.757+21.2553*0.385

= -36+40.01+8.18

= $12.19 million

The NPV of the project is $12.19million