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

$1.3

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

$17

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	35.000	35.000		35.000	35.000
−Cost of goods sold	21.000	21.000		21.000	21.000
=Gross profit	14.000	14.000		14.000	14.000
−​General, ​sales, and administrative expenses	1.360	1.360		1.360	1.360
−Depreciation	1.700	1.700		1.700	1.700
=Net operating income	10.940	10.940		10.940	10.940
−Income tax	3.829	3.829		3.829	3.829
=Net income	7.111	7.111		7.111	7.111

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

30%

on the equipment for tax purposes. The report concludes that because the project will increase earnings by

$7.111

million per year for 10​ years, the project is worth

$71.11

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

$9

million in working capital up front​ (year 0), which will be fully recovered in year 10. Next you see they have attributed

$1.36

million of​ selling, general and administrative expenses to the​ project, but you know that

$0.68

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?

Answer 1

INFORMATION GIVEN IN QUESTION:

Estimates of the new project for 10 years is given. It generates a Net income after tax of $ 7.111M every year for 10 years. Some items need reconsideration to arrive at every year cash flow through out the life of Project.

ANSWER:

(in millions of​ dollars)

SR.NO	PARTICULARS	0	1	2	3	4	5	6	7	8	9	10	NOTES
1	NEW EQUIPMENT COST	( 17 )											Outflow in 0 year
2	WORKING CAPITAL	( 9 )										9	Outflow in 0 year & Inflow in last year
3	GROSS PROFIT		14	14	14	14	14	14	14	14	14	14	Inflow every year
4	(-) GENERAL SELLING & ADMIN EXPS (EXCLUDING FIXED COST)		(0.68)	(0.68)	(0.68)	(0.68)	(0.68)	(0.68)	(0.68)	(0.68)	(0.68)	(0.68)	Fixed cost is excluded as it will not affect the project cash flow.
5 = 3-4	NET PROFIT BEFORE TAX		13.32	13.32	13.32	13.32	13.32	13.32	13.32	13.32	13.32	13.32
6 = 5x35%	TAX @ 35%		(4.662)	(4.662)	(4.662)	(4.662)	(4.662)	(4.662)	(4.662)	(4.662)	(4.662)	(4.662)
7 = 5 - 6	NET PROFIT AFTER TAX		8.658	8.658	8.658	8.658	8.658	8.658	8.658	8.658	8.658	8.658
8	TAX SAVING ON DEPRECIATION (refer working)		1.79	1.25	0.87	0.61	0.43	0.30	0.21	0.15	0.10	0.07	CCA IS 30% decreasing balance method & TAX RATE IS 35%
1+2+7+8	NET CASH FLOW	(26)	10.448	9.908	9.528	9.268	9.088	8.958	8.868	8.808	8.758	17.728

HENCE, TOTAL OF FREE CASH FLOWS = $ 75.36 M

WORKING OF TAX SAVING ON DEPRECIATION

YEAR	OPENING	DEP 30%	TAX @ 35%
1	17	5.10	1.79
2	11.90	3.57	1.25
3	8.33	2.50	0.87
4	5.83	1.75	0.61
5	4.08	1.22	0.43
6	2.86	0.86	0.30
7	2.00	0.60	0.21
8	1.40	0.42	0.15
9	0.98	0.29	0.10
10	0.69	0.21	0.07